What is the difference between Growth and Dividend options of Mutual Funds?

Almost all Mutual Funds comes with two options - Growth and Dividend.

Let us understand the difference between the two with an example using Fixed Deposits.

Consider two Fixed Deposits, A and B both having 6% interest rate.

Say you invested Rs 100 in each of them.

Fixed Deposit A, pays out the interest amount (Rs. 6) every year to your bank account and continues with Rs. 100 as the base amount for the next year.

Fixed Deposit B, at the end of the year does not pay out the interest amount but adds it to the base amount for next year i.e. the base amount now becomes Rs 106. In the second year interest of 6% is earned on Rs 106 and gets added to the base amount for the next year i.e. Rs 112.36 and so on till you decide to 'break' the FD and take out your money.

In the above example, Fixed Deposit A is like the Dividend option and B is like the Growth option of a Mutual Fund.

In the dividend option of Mutual Fund, the profits that a Mutual Fund earns is periodically paid out to the investors. So for e.g. let's say the NAV at start is Rs 10. The fund's investments do well and the it makes profits. This is reflected in the NAV going up to say 12. Now, the Mutual Fund will pay out the profits i.e. Rs 2 for each Rs 10 to the investors (by cheque/direct deposit etc). The NAV of the Mutual Fund will also fall back to Rs 10 to reflect the money going out of the Mutual Fund. And repeat.

In the growth option of Mutual Fund, the Mutual Fund will retain the profits and reinvest them. So the NAV will go from 10 to 12 to 15 and so on. If you want to withdraw some money, then you will have to sell some units.

There are a few points to remember here -

  • The underlying portfolios of the dividend and the growth options are identical i.e. your money will be invested in exactly the same stocks/bonds.

  • The dividend paid out is nothing extra, it comes out of the NAV of the fund itself.

  • Growth funds lead to higher returns over time because of the compounding that happens since profits from one period become part of the base amount for second period and so on.

  • Since Mutual Funds can incur losses as well (esp. Equity Mutual Funds), the dividends are not fixed or guaranteed. Many times during down markets, Mutual Funds skip dividends because they have not made any profits.

  • Taxation of the dividend amount is different in case of Equity and Debt Mutual Funds. While dividends declared by Equity Mutual Funds are tax free and incur no TDS, dividends declared by Debt Mutual Funds incur a TDS of ~30%.

On Goalwise, all the funds that we recommend are Growth Funds.

The reason is that in general we are not investing to get some money back in our bank account periodically. Dividend option probably makes sense for a retiree (and in some cases of tax optimisation) but not for the majority of Goalwise users. If we don't need that money, then we should just let it stay invested and compound over time so that we get higher returns at the end. We can always withdraw whenever we want but till we don't, let it be.

If you take the example of a growing plant - in the dividend option, you pluck out all the new leaves periodically whereas in the growth option you let the plant grow without disturbing it.

Which one do you think will grow to become a big tree?