I've always seen a mutual fund with two types (specifically pointing to Indian mutual funds) that are XYZ - Dividend/XYZ - Growth mutual fund? What exactly they mean here?
Which is the best to buy?
The difference between dividend and growth in mutual funds has to do with the types of stocks the mutual fund invests in. Typically a company in the early stages are considered growth investments. In this phase the company needs to keep most of its profits to reinvest in the business. Typically once a company gets a significant size the company's growth prospects are not as good so the company pays some of its profits in the form of a dividend to the shareholders.
As far as which is the best buy is totally a personal choice. There will be times when one is better then the other. Most likely you will want to "diversify" and invest in both types.
After searching a bit and talking to some investment advisors in India I got below information. So thought of posting it so that others can get benefited. This is specific to indian mutual funds, not sure whether this is same for other markets. Even currency used for examples is also indian rupee.
A mutual fund generally offers two schemes: dividend and growth.
The dividend option does not re-invest the profits made by the fund though its investments. Instead, it is given to the investor from time to time.
In the growth scheme, all profits made by the fund are ploughed back into the scheme. This causes the NAV to rise over time.
The impact on the NAV
The NAV of the growth option will always be higher than that of the dividend option because money is going back into the scheme and not given to investors.
How does this impact us?
We don't gain or lose per se by selecting any one scheme.
Either we make the choice to get the money regularly (dividend) or at one go (growth).
If we choose the growth option, we can make money by selling the units at a high NAV at a later date.
If we choose the dividend option, we will get the money time and again as well as avail of a higher NAV (though the NAV here is not as high as that of a growth option).
Say there is a fund with an NAV of Rs 18. It declares a dividend of 20%. This means it will pay 20% of the face value.
The face value of a mutual fund unit is 10 (its NAV in this case is 18).
So it will give us Rs 2 per unit. If we own 1,000 units of the fund, we will get Rs 2,000.
Since it has paid Rs 2 per unit, the NAV will fall from Rs 18 to Rs 16.
If we invest in the growth option, we can sell the units for Rs 18.
If we invest in the dividend option, we can sell the units for Rs 16, since we already made a profit of Rs 2 per unit earlier.
What we must know about dividends
The dividend is not guaranteed.
If a fund declared dividends twice last year, it does not mean it will do so again this year. We could get a dividend just once or we might not even get it this year.
Remember, though, declaring a dividend is solely at the fund's discretion; the periodicity is not certain nor is the amount fixed.
A growth fund is looking to invest in stocks that will appreciate in stock price over time as the companies grow revenues and market share.
A dividend fund is looking to invest in stocks of companies that pay dividends per share. These may also be called "income" funds.
In general, growth stocks tend to be younger companies and tend to have a higher volatility - larger up and down swings in stock price as compared to more established companies. So, growth stocks are a little riskier than stocks of more established/stable companies.
Stocks that pay dividends are usually more established companies with a good revenue stream and well established market share who don't expect to grow the company by leaps and bounds. Having a stable balance sheet over several years and paying dividends to shareholders tends to stabilize the stock price - lower volatility, less speculation, smaller swings in stock price. So, income stocks are considered lower risk than growth stocks.
Funds that invest in dividend stocks are looking for steady reliable returns - not necessarily the highest possible return. They will favor lower, more reliable returns in order to avoid the drama of high volatility and possible loss of capital.
Funds that invest in growth stocks are looking for higher returns, but with that comes a greater risk of losing value. If the fund manager believes an industry sector is on a growth path, the fund may invest in several small promising companies in the hopes that one or two of them will do very well and make up for lackluster performance by the rest.
As with all stock investments, there are no guarantees. Investing in funds instead of individual stocks allows you invest in multiple companies to ride the average - avoid large losses if a single company takes a sudden downturn. Dividend funds can lose value if the market in general or the industry sector that the fund focuses on takes a downturn.
I wrote about this a while back: http://blog.investraction.com/2006/10/mutual-funds-dividend-option-or-growth.html
In short: Growth options of a mutual fund scheme don't pay out any money, they reinvest the dividend they receive. Dividend options pay out some money, at different intervals, based on the surplus they accumulate. In India, the options have very similar underlying portfolios, so HDFC Equity Fund (Growth) and HDFC Equity Fund (dividend) will have the same percentage allocation to each stock.
Update: I also have a video you might want to see on the subject: http://www.youtube.com/watch?v=Bx8QtnccfZk