Investors invest in mutual funds for long-term capital gains, or regular cash flows through dividends. But did you know that if you opt for the dividend option, it can impact your returns? You will not get the full benefit of compounding due to the regular cash outflows in the form of dividends. This blog will focus on the IDCW plan in mutual funds – How does it impact your returns. Before that, let us understand what is IDCW in mutual fund.
What is IDCW in mutual fund?
The answer to what is IDCW in mutual fund is very simple. When you invest in mutual funds, you can opt for either the growth option or the IDCW option. IDCW stands for income distribution cum capital withdrawal. From time to time, the fund manager books profits by selling the securities at a higher price than the price at which they were bought. The profit is shared with the unitholders.
The unitholders who opt for the IDCW option get back their share of the profit in the form of IDCW. The IDCW was earlier known as the dividend option. For the unitholders who opt for the growth option, their share of the profit is reinvested in the scheme. This pretty much sums up what is IDCW in mutual fund.
Why did SEBI change the terminology to IDCW?
SEBI renamed the dividend option to IDCW in April 2021. SEBI took this step to clarify to investors that mutual fund dividends are not an added bonus for investors over and above the capital gain. Dividends are paid from the scheme money, which anyways belongs to unitholders. When a mutual fund scheme declares a dividend, the NAV of the scheme gets reduced by the dividend per unit.
For example, the NAV of a scheme is Rs. 30 per unit. The scheme declares a dividend of Rs. 3 per unit. In this case, the scheme NAV will adjust to Rs. 27 per unit. So, the investor will get a dividend of Rs. 3 per unit, and the NAV of their units will be Rs. 27 per unit. So there is no real gain for the investor after the dividend payment.
How does IDCW impact your returns?
In the above section, we understood what is IDCW in mutual fund & how there is no real gain for an investor after the dividend payment. On the contrary, opting for the dividend payout option impacts the investor’s compounding.
Let us understand this with an example. Ajay and Vijay hold 1,000 units in a mutual fund scheme. The NAV is Rs. 50. Ajay has opted for the growth option, and Vijay has opted for the IDCW option. At the end of the first year, the scheme declares a dividend of Rs. 4 per unit. After dividend payment, Ajay and Vijay’s holdings will look like this.
|Number of units||1,000||1,000|
|NAV per unit||Rs. 50||Rs. 50|
|Value of total holding||Rs. 50,000||Rs. 50,000|
|Dividend declaration||Nil (Growth option)||Rs. 4 per unit|
|NAV after the dividend payment||Rs. 50||Rs. 46|
|Value of holding after the dividend payment||Rs. 50,000||Rs. 46,000|
As seen in the above table, after dividend payment, the value of Vijay’s holding is Rs. 46,000, and Ajay’s holding remains at Rs. 50,000. Vijay has got a cash flow of Rs. 4,000 in the form of dividend payment.
At the end of the second year, the scheme has given a return of 15% and has declared a dividend of Rs. 5 per unit. Ajay and Vijay’s holdings will look like this.
|Number of units||1,000||1,000|
|NAV per unit (15% growth)||Rs. 57.5||Rs. 52.9|
|Value of total holding||Rs. 57,500||Rs. 52,900|
|Dividend declaration||Nil (Growth option)||Rs. 5 per unit|
|NAV after the dividend payment||Rs. 57.5||Rs. 47.9|
|Value of holding after the dividend payment||Rs. 57,500||Rs. 47,900|
The above table shows how Ajay’s holding of Rs. 57,200 is higher by 20% than Vijay’s holding of Rs. 47,900 in two years.
Choose growth over IDCW to benefit from compounding
When you choose the IDCW option, you get a cash flow from the scheme whenever it declares a dividend. The cash outflow from your scheme investment reduces the accumulated corpus by the dividend amount. It impacts the compounding of your wealth.
When you choose the growth option, your dividend amount is reinvested in the scheme. The growth option allows your money to stay invested in the scheme and benefit from the power of compounding. When your money stays invested, you earn a profit on profit through compounding. It results in your corpus growing higher and creating wealth for you.
Now that you understand the meaning of what is IDCW in mutual funds, you need to evaluate whether you should opt for the growth or IDCW option. You may opt for the IDCW option if you need regular cash flows. However, if you want your money to stay invested for the long term till your financial goals are met, you should opt for the growth option.