If you are planning to buy a mutual fund or brought a fund earlier, you would have noticed mutual fund companies asking you to select an option between growth or Income Distribution cum Capital Withdrawal (IDCW).
Are you aware of these options use-case and their long-term results? Let’s discuss.
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To understand the benefits and drawbacks of dividend and growth options, we should understand how our returns from mutual funds are calculated.
We can earn from mutual funds in two ways: capital appreciation and dividends.
A mutual fund’s dividend is quite similar to an individual stock’s. You receive some cash as per the unit or shares you hold. If a fund house has announced ₹5 as a dividend per unit and you own 100 units, you will receive ₹500 as a cash dividend.
But how is capital appreciation calculated for mutual funds? In individual shares, we have the share price per stock to calculate it.
Let’s say you own reliance company share. The share price was around ₹2000 when you bought it, and now it’s priced at ₹2500. So your capital appreciation return is 25%.
Simple, right? For mutual funds, we have a similar metric to calculate our returns. We use Net Asset Value (NAV).
What is NAV?
NAV is the total market value of the stock or bonds owned by the mutual fund.
As we know, mutual funds invest the money collected from investors in equity, bonds, and other assets. Since the market value of these assets changes every day, the NAV of a fund also varies on a day-to-day basis.
The NAV per unit is the market value of assets owned by the fund divided by the total number of units of the fund.
Let’s say fund A invests in equity 100%. Today the market price of all these equities owned by fund A is around ₹100 cr. And the fund has 1 cr units in total. Thus, ₹100 cr divided by 1 cr units gives us a NAV of ₹100. (Check out this video to understand NAV with cheese masala dosa.)
Now, as the market price of the equities changes every day, the NAV changes, too. If the market price of the total equities owned increases to ₹102 cr, then the NAV increases to ₹102.
This makes our capital appreciation returns calculation easy, right? If you bought the mutual fund units at ₹100 and the NAV increases to ₹110 in a year, your return is 10%.
So, we have understood how capital appreciation and dividend return works. As many investors invest in mutual funds with different goals and objectives, fund houses provide the option of growth and IDCW.
These options have a considerable effect on how you receive your returns, so it is essential to be aware of these options.
In the growth fund, the fund pays no dividend to the investors. Instead, it keeps reinvesting the returns it generates over the years.
For example, let’s say fund A earns a return of 10% every year, and it has ₹100 cr Asset Under Management (AUM) in the first year. With the returns, the AUM increases to ₹110 cr in the 2nd year and in the 3rd year; it increases to ₹121 cr. (Excluding the fund expense part for simple explanation)
If mutual fund A has 1 cr units, the NAV of the fund will be ₹100 in the first year. ₹110 in the 2nd and ₹121 in the 3rd year. So, you have received a compound return of 10% for two years from the fund.
Compounded because you don’t withdraw any profits and keep reinvesting them. Over the years, these profits will earn you more profit.
Therefore, the growth option is the best for wealth accumulation.
Now, let’s look at the second option, IDCW.
Income Distribution cum Capital Withdrawal (IDCW)
As the name suggests, this fund withdraws some portions of the profit earned and distributes it among the unitholders. The fund can do this in two ways: dividend payout and dividend reinvestment.
If you select this option while buying a mutual fund, the fund periodically withdraws some portion of the profits and shares it with you as a cash dividend.
So, you receive your returns from this fund in two ways: NAV price appreciation and dividends.
Now on paper, the idea of receiving returns in two ways sounds exciting, but it is not. In the growth option, the fund never withdrew the profits and kept reinvesting them, leading to more compounding returns. NAV keeps increasing as the assets owned keep increasing.
But in the dividend option, the fund withdraws profits and shares them with you. This means the assets owned decrease every time the fund withdraws profit and shares it with you. So the NAV decreases too.
Let’s say fund B shares 20% of the profit every year as dividends. It generates 10% returns on a ₹100 cr AUM. The NAV at the end of the 1st year before sharing the dividend is ₹110. After the dividend, the NAV drops to ₹108 as the fund shares a dividend of ₹2 per unit (20% of the profit).
So next year, the NAV would be ₹118.8 in the dividend option, whereas the NAV was ₹121 in the growth option. But you have also received a total of ₹4.16 per unit in those 2 years.
This means your total returns have been the same in both options. You just withdrew some portion of your returns in the form of the cash dividend.
So should you select this option while selecting a mutual fund? Our suggestion will be no. Because in the long term, you lose out on the compounding magic that the growth fund provides you.
Only select the dividend option if you depend on receiving some income here and there from your investments.
Why did we say here and there? Because these funds don’t promise to share the dividends at regular intervals.
Now, what is the other option in IDCW?
In this option, the fund declares the dividend from the profit. The NAV reduces similar to the dividend payout option.
But you don’t receive the dividend in cash. Instead, the fund allots extra fund units to you of the same value. Let’s say you owned 1000 units before. After the dividend, the fund allots you 100 additional units based on the value of the dividend.
Not all mutual fund companies provide both dividend options. Most provide growth and dividend payout options only.
Based on preference and objectives, select the mutual fund option wisely. Also, don’t forget that dividends attract a tax based on your income slab.
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