Life was easy once upon a time. Mutual funds were mutual funds and there were not many options to choose from. You had money and a mutual fund company had a scheme. You put your money in a scheme of a particular mutual fund and earned returns on it.

That was once upon a time. Now you have a dime a dozen mutual funds and each fund has scores of schemes. You have mutual fund schemes in the market today that offer you a number of options.

Like a growth-oriented mutual fund, a mutual fund that offers you dividends (an amount that a mutual fund distributes amongst its investors from the profits it makes) at regular investments and a mutual fund that pays you dividends only to reinvest the same amount and give you more units of the same.

So what do you as an investor do? While there are numerous schemes with very attractive names that fight for your attention in the marketplace, here I will confine myself on helping you analyse the most popular dividend-paying MF scheme and a growth-oriented MF scheme. That is, which of the two is better.

When I began my journey into the mutual fund industry I too was excited whenever a dividend was declared. The reason was that, I thought, I did not have to sell the units of the mutual fund scheme that was declaring a dividend. People, too, used to come to me and say that they wanted to buy a scheme declaring a dividend.

But slowly I started to learn all about mutual funds by asking all sorts of questions. And there were so many related to dividends. It took a while for me to realise that dividend is not something more or extra that a mutual fund was giving its investors, but a part of the investors' own money being returned to her/him in the form of dividends.

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Remember that any mutual fund pays dividends out of the gains it generates. The effect of this is that the fund size reduces by the amount of money distributed. This is also reflected in the drop in the net asset value, NAV, of the dividend option (by the amount of dividend per unit distributed).

Let's understand this better. Say a mutual fund collects Rs 100 crore from its investors and on this amount makes a profit of Rs 20 crore. At this point the NAV of your unit increases from Rs 10 to Rs 12. If your mutual fund declares a dividend of Rs 2 then the value of your units will automatically come down to Rs 10 (Rs 12 less the dividend of Rs 2) on the day this takes effect.

In effect, the mutual fund returns your own money back to you.

But we also need to understand that when a dividend is declared, a lot of new investors put their money in the mutual fund with the intention of getting the dividend. This is possible because there is a gap between the date when a MF scheme declares dividends and the actual date when the dividend reaches investors' bank accounts.

Some funds may do it purely to attract more money from new investors. The rationale is that dividend is a way to distribute profits generated at regular intervals, especially when markets are overheated and there are not so many good opportunities to invest.

From my experiences in dealing with a lot of individual investors and also different types of mutual funds, I have found that a majority of investors still do not have complete understanding about dividends declared by a mutual fund. The tax aspect adds to the confusion. Now let me throw some light on this issue so that it enables you to take a more informed decision.

For simplicity, let me limit my scope to the equity-oriented mutual funds. To qualify as an equity-oriented mutual fund, the minimum holding a fund needs to have in equities is 65 per cent and above. That is if a fund collects Rs 100 crore then at least Rs 65 crore or more needs to be invested in equities.

When investing into any mutual fund scheme investors are required to select one among three options -- growth, dividend payout or dividend reinvestment.

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I have read in a lot of places where advice is given that if a person requires regular income s/he should opt for a dividend scheme. There is no rational basis for this advice in case of equity-oriented mutual funds.

The reason is that there is no set schedule of payment of dividend. Also how much dividend will be paid is not predictable. And if a person needs cash flow, s/he cannot depend on the unpredictability of when and how much dividend will be declared for her/his regular need. 

If this is not the reason for not opting for a dividend scheme, then what is?

Here I would like to ask a simple question. Why do you invest money in a mutual fund in the first place? Is it for dividends or for returns? If your answer is returns and that is your objective, then the decision to select the option should be based on the objective of making maximum return -- be it either through the dividend option or through the growth option.

To enable us to make the best decision we need to understand the taxation aspect involved when a mutual fund scheme declares dividends.

Investors should opt for an option that minimises their tax liability. Currently dividend income from equity mutual funds is tax-free; also there is no dividend distribution tax.

Secondly, long-term capital gains (all gains arising after sale of units held for more than one year) too are tax-free.

In such a scenario, if the investor plans to invest for a period of less than a year then dividend option seems better (as you won't have to pay in tax in case you sell your units). But here, let me point out that equity as an asset class is for long term investing (say a 5 year horizon is good in current scenario). So, investing in a mutual fund for less than a year does not make financial sense because returns would be lower.

Hence if you are a serious investor into equity mutual funds your horizon should anyways be greater than one year and hence growth option would be more suitable as long term capital gains tax is nil.

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The fact that under the dividend option the fund keeps on declaring regular dividends and no such payments accrue under the growth option might suggest to some investors that the former is better. However, if we compare returns from a dividend reinvestment scheme to that of a growth scheme, there would be no difference in the final returns.

But in case of the dividend payout there would be some difference because the money is returned to the investor in the form of cash. It would depend on what the investor does with this cash. 

Also, there is one more very relevant issue. In an ELSS (Tax saving mutual fund where you cannot withdraw money before 3 years from the date of investment) scheme, if you select the dividend reinvestment option you will be locked in for life.

In this option, instead of paying money to you in the form of dividends the mutual fund puts back the same amount in the same scheme and gives you equivalent number of units.

The reason is that when the dividend is reinvested new units are issued. These units would be locked in for a further three-year period from the date of issue (remember this is an ELSS scheme with a three-year lock-in period).

And as dividend continues to be given within the next 3 years on the new units you received, you will find yourself locked in for life.

In conclusion, the truth is that it does not make much difference which option you choose (provided you are a long term investor), from the return point of view.

Disclaimer: The intention of the article is only to make investors aware of the mystery surrounding the dividend option in mutual funds. Investors must evaluate their individual objectives of investing before they decide on which option best suits their objective.