When stocks pay dividend, it essentially means that the company is sharing profit with the shareholders, but in the case of Mutual Funds paying dividend, they actually return a part of your capital back to you.
Many people get trapped by the high dividend paying mutual fund schemes without understanding the truth behind it. Distributors mis-sell investment schemes to investors on wrong knowledge. This is especially true in the case of equity-linked saving schemes (ELSS), where large dividends are given out as year end approaches and investors are lured into investing in these, based on a promise of quick return on capital.
Dividend payout on investments in mutual fund and stocks is different. But, investors think the significance is similar in both cases. If TCS gives you a dividend, it transfers money from its profit , that is, over and above the money you've put in to buy the stock. In fact, the dividend is extra gains for you, over the gains from stock price movement. However, mutual fund houses pay money from your investments as dividend. It’s basically just your money coming back to you.
After Mutual Funds declare dividend the Net Asset Value (NAV) of the MF unit falls by the amount of dividend paid. The term ‘dividend’ should be dropped altogether and classify all income from mutual funds as capital gain. Sample this, when the mutual fund pays you money, it is called dividend. When you withdraw an equivalent amount from the scheme, it is called capital gain. Same amount, different terms, different tax treatment. It is being misused for vested interests at the cost of lay investors.
However, investors should avoid investing in dividend option of mutual funds. in the dividend payout you lose, on compounding returns as the dividend you receive is not re-invested either by the scheme or the investor. Unlike the dividend option, the growth option reinvests the gains over and over again and the returns are compounded, resulting in higher proceed, at the time of maturity. The dividend option works best when valuations of the market seem high. When markets are at a high, the likelihood of the fund house declaring a dividend is higher. But, the amount and frequency of dividends is never guaranteed.
On the contrary, in the growth option, profits made by the scheme are invested back into it. This results in the NAV of the scheme rising over time. When the scheme gains, the NAV rises and in case of a loss, it goes down. Those who want to create wealth or have a goal to fulfil over a longer period of time should choose the growth option. Typically, those with regular income flow are advised to invest in the growth option. Those looking for a regular income such as retirees, should pitch for the dividend option.