FundsIndia explains: Why the growth option is preferable

Over the past few weeks, we have been explaining various aspects of dividends in mutual funds. You know how a mutual fund makes dividends, what happens when a fund declares a dividend, and how it affects your NAV. We, and most advisors, usually recommend that you opt for growth when investing rather than dividend, especially if you are a long-term investor.

Many of you may wonder why. After all, when you look at the returns figures in the growth and dividend plan of a fund, it is the same.

There is only one portfolio for a scheme. The performance of this portfolio is what you see. Take the returns numbers for a fund that you see on any website or factsheet. Those returns are for the scheme itself – it is how the stocks or bonds that the fund held returned. Remember that the NAV is just a tool used to account for investors in the fund. A fund does not maintain a separate dividend plan portfolio and a growth plan portfolio. To the portfolio itself, whether you hold the dividend plan or growth is immaterial. When websites or funds show returns, they are showing the performance of the fund, and not the plan. You could argue that returns come from movement in NAVs and the NAV of dividend plans have the dividend stripped off. Well, where websites list dividend plans separately (very few show it distinctly like that), they assume reinvestment of dividend when they show the returns.

It does not matter how many units you have. You see the dividend and growth plans returning the same. Seeing this, you conclude that the dividend plan will give you extra returns and you get more units because the NAV is lower. No. A lower NAV is not better than or worse than a higher NAV. The change in the NAV or the percentage to which it moves up or down is what matters and not the absolute NAV figure. The NAV represents the per-unit value of your investment in the fund and is independent of the fund’s portfolio itself. What is important is the amount you have invested.

You have lower compounding and thus lower returns in dividend plans. A fund declares dividend out of its distributable surplus. It pays you out of your own NAV, deducting the dividend from the NAV and giving it to you. This effectively translates into you booking profits in your fund. You receive the proceeds in your bank account, where it idles, or it is spent. In routinely getting dividends, you are routinely booking profits and forgoing compounding benefits. In the growth plan, your returns remain with the fund and it compounds – you are allowing the returns you earn to stay invested which in turn make returns. That is what compounding is all about. As you take out your returns in the dividend option, you lose this because only your initial investment stays. Here is an illustration, assuming an investment of Rs 10,000 in Birla Sun Life Frontline Equity (used for illustrative purposes only). You see how the worth of your investment in the dividend option, even including the dividend received, is much lower than the growth option. Unless you were to reinvest this dividend diligently, your returns will be lower. And if you were going to reinvest dividends, why go for the dividend option in the first place?

For debt funds, you’re paying tax on dividends. For debt funds, the dividend is taxed at 28.8%. The AMC deducts this tax from the NAV along with the dividend. So not only is your dividend going to reduce compounding, you’re hurting your returns more by paying this tax. Even if you choose dividend reinvestment option, you’re still paying tax.

Your dividends are not fixed or even guaranteed; you cannot rely on them. The surplus that an equity fund generates differs from month to month depending on the market, the calls the fund takes, and the dividend it receives from stocks it holds. A debt fund is a bit more certain of its surplus since it knows the interest that accrues. But even then, the surplus will change as the instruments it holds change and the calls the fund takes. If there is no certainty on the exact surplus, your dividend can be neither fixed nor guaranteed. The table above is an example of how dividends vary. Thus, relying on dividend for income is not a good idea if you need a certain cash flow each month. The best way for regular cash flows is to go for the growth option and withdraw from your funds systematically. This is especially true for those in the 10% and 20% tax brackets. Those in the 30% tax bracket will have to pay only a slightly higher tax for three years, after which indexation benefits significantly reduce tax outgo.

For long-term investments, the growth option is the only way to get the best return. The longer you stay invested, the greater is the compounding and the more your returns.