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Simply put, in a growth plan, the gains made by a mutual fund scheme are re-invested. Therefore, the net asset value (NAV) moves up. In a dividend plan, the gains are periodically distributed as dividend. So the NAV drops to the extent of the dividend, whenever it is paid out.
Dividend re-investment is a facility to put the dividend back into the scheme, thereby buying up some more units. Dividends are tax free, whereas an investor who sells his or her units to earn the gains will have to pay capital gains tax on the gains, depending on the holding period.
Therefore, investors who need income should choose dividend plan, and investors who can hold for longer period, should choose the growth option.
In an equity fund, gains realised after one-year holding period are also not taxed.
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Investors believe that after the dividend is distributed, growth NAV and dividend NAV do not appreciate or depreciate in the same proportion.
In other words they believe that since the growth NAV is higher than the dividend NAV, it has appreciated more than the dividend NAV.
Therefore, they think that they are better off selecting the growth option as opposed to the dividend option.
While there are several reasons why investors must choose a particular option (growth or dividend), this is certainly not one of them, mainly because the reality behind the discrepancy between the two options is far from the perception.
Once a dividend is declared by the mutual fund, the dividend option NAV diminishes to the extent of the dividend declared.
The growth option NAV on the other hand remains unchanged (for simplicity's sake we have ignored the market movement on that particular day).
The diminution in the dividend option NAV equals the amount of dividend declared.
For instance, in our illustration (refer table below) both the growth and dividend NAVs have appreciated by 20 per cent from the NFO (new fund offer) period to close at Rs 12. The mutual fund declares 10 per cent dividend after which the dividend NAV declines to Rs 11 (ex-dividend).
The growth NAV on the other hand remains unchanged at Rs 12.
A matter of dividend
The difference between the growth and dividend NAVs will equal the dividend declared (that is, Re 1).
However, the difference in both the NAVs will equal the dividend declared only on the day of the dividend declaration. The next day this difference will vary (from Re 1 in this case) based on the market movement.
For instance, let's assume that markets appreciate by 10 per cent over one-month after the dividend declaration. In that case, the growth option will rise from Rs 12 to Rs 13.2, while the dividend option will rise from Rs 11 to Rs 12.1.
The 10 per cent growth in NAV is based on the value of the portfolio's investments. Therefore, although the growth NAV seems higher compared to the dividend NAV, both NAVs have appreciated proportionately.
The difference between the options is now Rs 1.1 while at the time of the dividend declaration it was Re 1.
What should investors do?
As we have impressed no matter what option the investor chooses, dividend and growth NAVs will appreciate/depreciate based on the market movement; there is no other factor at play over here. Which option -- growth or dividend -- to select is dictated entirely by the investor's investment objective and income/liquidity constraints.