Sunday, August 24, 2008

Growth or dividend fund -- which is better?

Two friends of mine were totally flummoxed the other day.

Both had invested in the HDFC [Get Quote] Growth Fund. Yet, on March 14, one claimed the Net Asset Value was 17.4150. The other was certain it was 25.2930.

The NAV refers to the price of one unit of a fund. The question that bothered them both was: how could there be two NAVs for one fund?

Simple. Each had bought a different scheme under the same fund. One had bought units of the dividend option scheme and the other, the growth option scheme.

Confused? Let's make it clearer.

Know the difference

A mutual fund generally offers two schemes: dividend and growth.

The dividend option does not re-invest the profits made by the fund though its investments. Instead, it is given to the investor from time to time.

In the growth scheme, all profits made by the fund are ploughed back into the scheme. This causes the NAV to rise over time.

The impact on the NAV

The NAV of the growth option will always be higher than that of the dividend option because money is going back into the scheme and not given to investors.

In the above example of the HDFC Growth Fund, the NAV of the dividend option was 17.4150, while the NAV of the growth option was 25.2930.

How does this impact you?

You don't gain or lose per se by selecting any one scheme.

Either you make the choice to get the money regularly (dividend) or at one go (growth).

If you choose the growth option, you can make money by selling the units at a high NAV at a later date.

If you choose the dividend option, you will get the money time and again as well as avail of a higher NAV (though the NAV here is not as high as that of a growth option).

Say there is a fund with an NAV of Rs 18. It declares a dividend of 20%. This means it will pay 20% of the face value.

The face value of a mutual fund unit is 10 (its NAV in this case is 18).

So it will give you Rs 2 per unit. If you own 1,000 units of the fund, you will get Rs 2,000.

Since it has paid Rs 2 per unit, the NAV will fall from Rs 18 to Rs 16.

If you invest in the growth option, you can sell the units for Rs 18.

If you invest in the dividend option, you can sell the units for Rs 16, since you already made a profit of Rs 2 per unit earlier.

What you must know about dividends

The dividend is not guaranteed.

If a fund declared dividends twice last year, it does not mean it will do so again this year. You could get a dividend just once or you might not even get it this year.

Generally, funds whose NAV is above 10 are in a position to consider a dividend. Remember, though, declaring a dividend is solely at the fund's discretion; the periodicity is not certain nor is the amount fixed.

Which should you take?

This depends on your overall investments and income.

If you are looking at a long-term investment and are not interested in money being given to you at various intervals, the growth option is meant for you.

If you are keen on receiving an income at various intervals, opt for the dividend option.

The tax impact

Dividends from a mutual fund are not taxed.

Now for a look at the tax impact when you sell the units.

When you sell the units of a mutual fund and make a profit, it is known as capital gain.

Equity and equity related funds

These would entail two types of funds:

An equity fund (invests in shares)
A balanced fund (invests in shares and fixed income instruments) that has more than 50% of its investments in shares.
If you sell the units of such funds within a year of your purchase, the profit on this sale is called a short-term capital gain. You will be taxed 10% on short-term capital gain.

If you make a make a profit by selling the units after a year, it is called long-term capital gain. This is not taxed.

Debt funds

These are funds that invest in fixed income instruments (investments that give you a fixed return, like fixed deposits and bonds) and not in the stock market.

If you sell the units of such a fund within a year of your purchase, the profit you make is called is short-term capital gain. It will be added to your total income and you will be taxed as per the tax bracket you now fall under.

This is how short-term capital gain is taxed.

If you make a profit by selling these units after a year, it is called a long-term capital gain.

In this case, indexation is taken into account (a type of computation that takes inflation into account).

So the tax is the lower of these:

20% (of the long-term capital gain) + surcharge and cess levied by the government after taking indexation into account.
10% (of the long-term capital gain) + surcharge and cess without taking indexation into account.
To understand indexation, please read All you wanted to know about capital gain.

Before you take a call on which investment option you want, do take into account the tax impact and your income requirements.

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