Impact of Dividend vs Growth Options in Mutual Funds

Dividends in Mutual Funds

Dividends in mutual funds are now known as Income Distribution Cum Capital Withdrawal (IDCW). As of April 1, 2021, the nomenclature of ‘Dividend’ changed. Mutual funds no longer have a category referred to as ‘Dividends.’ The term ‘Dividend’ has been replaced with ‘distribution.’ Additionally, the ‘Dividend Plan’ of a Mutual Fund scheme has been rebranded as the IDCW.

The ‘Dividend Plan’ nomenclature has misled many Mutual Fund investors into thinking it is a bonus on top of the returns their scheme provides. This was quite misleading because when a mutual fund scheme pays dividends, it is essentially taking some of the money that already belonged to the investors and distributing it to them.

Impact of Dividend (IDCW) on Mutual Funds

Let’s understand the impact of IDCW on your mutual fund investment with an example. If you own 10,000 units in a mutual fund scheme with a NAV of Rs. 30, and the fund announces a dividend of Rs. 2 per unit, you will receive a dividend of Rs. 20,000 for your 10,000 units.

However, this amount does not represent additional income. The mutual fund scheme will deduct the Rs. 20,000 paid to you as a dividend from your investment. On the day the scheme initiates the transaction to pay out the dividend, the NAV of the scheme will decrease by Rs. 2, dropping from Rs. 30 to Rs. 28.

In simpler terms, the mutual fund scheme will pay you Rs. 20,000 as a dividend, causing your investment in that scheme to decrease from Rs. 3 lakhs to Rs. 2.8 lakhs.

Mutual fund schemes essentially redistribute a portion of your existing funds back to you in the form of dividends. This is precisely captured by SEBI’s newly coined term - IDCW.

Growth Option in Mutual Funds

Growth options in mutual funds prioritize capital appreciation. Instead of receiving regular payouts, investors reinvest their earnings into the fund. This can lead to the compounding of returns over time, potentially resulting in significant wealth accumulation.

Suppose you’ve 1000 units of an equity fund at an NAV of Rs 40. In one year, the NAV of the scheme increases to Rs 50 under the growth option. You then sell the units, earning a sum of Rs 50,000 — consequently, your profits from the investment amount to Rs 10,000 (Rs 50,000 - Rs 40,000).

Reinvesting earnings allows for compounding, where returns generate additional returns. Over the long term, this compounding effect can significantly boost the overall value of the investment.

Dividend (IDCW) and Growth Option - The Differences

The table below captures the differences between IDCW and growth options on several parameters -

Choosing Between Dividends (IDCW) and Growth Options

The choice between dividends and growth options ultimately is based on your financial objectives, risk appetite, and investment horizon. Here are a few factors to consider when making this decision:

1. Income Needs: If you require regular income from your investments, dividends (IDCW) may be better. However, if you have other sources of income or a longer investment horizon, growth options may be more suitable.

2. Risk Appetite: Dividend-paying companies often have lower volatility, making them less risky. On the other hand, growth investments can be more volatile due to the nature of high-growth companies.

3. Tax Considerations: Investors in higher tax brackets may prefer growth options to defer taxes until they sell their shares, potentially benefiting from lower capital gains tax rates.

Summing it Up

Dividends (IDCW) and growth options in mutual funds offer distinct advantages and considerations for investors. While the former provides a regular income stream and stability, growth options focus on capital appreciation and potential long-term gains.