Dividend ETFs, or exchange-traded funds, provide a portfolio of stocks that offer investors the potential for growth as well as income in the form of regular dividend payouts.
Some investors may find dividend ETFs appealing because, like mutual funds, ETFs are invested in a range of stocks. As such they can add diversification to an investor’s portfolio by providing broad market exposure.
Because dividend ETFs are invested in dividend-paying stocks, there is the potential for income as well as growth. Dividends can also be reinvested in more ETF shares.
Unlike bond coupons, however, dividend payments are not guaranteed. Most dividend ETFs are passive in that they track an index of dividend stocks.
Key Points
• Dividend ETFs have a portfolio of stocks that pay dividends.
• Dividend stocks offer investors the potential for growth as well as income in the form of regular dividend payments, but companies are not required to pay dividends.
• An investor may be able to choose whether to take the dividend payouts or reinvest them in shares of the ETF.
• Most dividend ETFs are passively managed in that they track an index of domestic or international stocks.
• Dividend ETFs can follow different strategies, focusing on domestic, international, higher-yield or other securities.
ETFs Basics
An ETF is a fund that allows individuals to invest in a diversified basket of investments, such as stocks, bonds, and other assets.
Most ETFs are passively managed, meaning they track an index such as the S&P 500, which reflects the performance of the 500 largest U.S. stocks. But some ETFs are designed to capture the performance of a certain market sector, or rely on another strategy.
As the name suggests, exchange-traded funds are traded in real time on different stock exchanges, such as the New York Stock Exchange or Nasdaq. Investors buy shares of an ETF, and the price of the ETF fluctuates throughout the day. These funds can be bought and sold throughout the day.
ETFs vs. Mutual Funds
This is an important distinction from how mutual funds work, which also allow individuals to invest in a basket of investments. Mutual fund trading is settled once per day, at the end of the trading day.
Another important difference between ETFs and mutual funds is that ETFs typically have lower fees than mutual funds. Because ETFs that track an index are usually passively managed, they don’t require a lot of oversight from fund managers. Less time and energy from fund managers translates into lower fees that end up being passed on to investors.
How Dividend ETFs Work
A dividend ETF works much the same as a regular ETF, but the ETF’s portfolio is invested in dividend-paying equities, and they usually track part or all of a dividend stock index. For example, a dividend ETF might track the Dow Jones U.S. Select Dividend Index, which consists of 100 dividend-paying stocks.
Dividend stocks are securities that pay a portion of company profits out to shareholders. Those dividends are usually paid on a fixed schedule. The process involves four important dates: the declaration date, the date of record, and the payment date.
• The declaration date is the day the board of directors announces that it will pay a dividend.
• The date of record is when the company assesses which shareholders are entitled to a dividend.
• The ex-dividend date is the deadline for getting paid the dividend for that quarter (or period). If you purchase shares before the ex-dividend date, or ex-date, you qualify for the upcoming dividend payout.
If you purchase shares on or after the ex-dividend date, you’ll get dividends on the next payout schedule.
• The payment date is the day the dividends are paid to you directly, or through your brokerage. Sometimes there is a special payment date if the company has extra profits it wishes to distribute to shareholders. This is another reason to be aware of these important dates.
Dividends are usually distributed to shareholders in the form of cash, on a per-share basis (although, as noted, dividends can be reinvested in the company or ETF). For example, if a company pays a monthly dividend of 20 cents per share, an investor with 100 shares of stock would receive $20 per month.
Do ETFs Pay Dividends?
Dividend ETFs collect the dividend payments from their underlying stocks and make distributions to the ETF shareholders. The process of payment from a dividend ETFs mirrors that of single dividend stocks. There is a record date, ex-dividend date, and a payment date.
That said, the ETF’s schedule may be different from the schedules followed by its underlying stocks. Dividend ETFs usually make payments according to a regular schedule, which is described in the fund’s prospectus and is publicly available.
Recommended: What are Dividends and How Do They Work?
Types of Dividends
Qualified dividends are those that can be taxed at the capital gains rate. The capital gains rate then depends on the investor’s modified adjusted gross income (MAGI). This is also known as the preferential rate.
In contrast, ordinary or nonqualified dividends are taxed at income tax rates, which are generally higher than capital gains tax rates.
To get qualified dividends, the company must meet certain criteria, and the investor must hold the shares for a specified period. The Internal Revenue Service (IRS) requires that investors hold shares for more than 60 days during a 121-day period. The period starts 60 days before the ex-dividend date.
💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).
How Dividend ETFs Are Taxed
ETFs may also be more tax efficient than other similar investments. That’s because they’re passive investments with little turnover in the holdings. The process of creating and redeeming ETF shares are also not subject to capital gains taxes on any individual security within the fund.
Dividend ETFs are a little bit more complicated when it comes to taxes due to the way dividends are taxed by the IRS. There’s no escaping tax on dividends. Shareholder dividends are taxable in the year that they are received whether they are paid in cash or whether they are reinvested. The first thing to pay attention to is whether you are receiving qualified dividends or ordinary dividends.
• Most dividends, whether from stocks or ETFs, are considered ordinary, or nonqualified dividends. Ordinary dividends are taxed as income, based on your tax rate.
• Qualified dividends must meet certain IRS criteria: i.e., they must be paid by a U.S. company (or a qualifying foreign company), and a certain required holding period must be met to qualify for the capital gains rate.
To qualify for any dividend payout, from a stock or ETF, you must buy shares before the ex-dividend date.
Then, to qualify for the lower capital gains rate, the basic rule of thumb is that you have to hold the security for at least 60 days within a specific 121-day period. Many dividend ETFs offer qualified dividends, but it’s important to check the prospectus to understand the holding period.
Recommended: Active vs Passive Investing: Differences Explained
Types of Dividend ETFs
There are hundreds of dividend ETFs that can track all sorts of indexes. Some may track global indexes, while some may target specific indexes by country or market sector, or companies of a certain size. Some track bond indexes of varying risk. And others target real estate or currency or alternatives.
Investors can take a look at what’s available by looking at the ETF Database directory, an online resource.
Here’s a closer look at just a few categories of dividend ETFs that investors may encounter:
Dividend Growth ETFs
A company that’s steadily growing its profits should theoretically be able to offer higher dividends in the future. That’s the reasoning behind dividend growth ETFs, which target companies that show increasing profits and sales.
Dividend Value ETFs
Value stocks vs. growth are those that operate in relatively stable industries, but are priced cheaply compared to the potential value of the company.
They typically have a low price-to-earnings ratio. The idea is that the company may experience a future jump in share price as investors catch on to the company’s true value. Shares inside the ETFs could provide a boost in price in addition to the dividends they provide.
High Dividend Yield ETFs
This category of ETFs goes after stocks that produce high dividend yields. But here’s the rub: While the payout for these stocks may be higher than others, it doesn’t necessarily mean that the stock will grow particularly fast. In other words, you may be trading swift share price growth for high dividend yields.
Also, as the stock price goes down, yield goes up. It’s counterintuitive, but the way this math works out may actually be masking the fact that you’re losing money on the price of the stock. Investors could potentially combat this by looking for ETFs that invest in stocks that at least keep pace with the market long-term.
Some dividend ETFs target the so-called “Dogs of the Dow.” The Dow is an index that comprises the 30 largest U.S. industrial stocks. The “dogs” are the 10 highest-paying dividend stocks within this index, yet they also tend to be the lowest performers when it comes to price gain.
Reinvesting Dividends
Reinvesting dividends is the process of using the income collected from shares of a dividend stock or dividend ETF and immediately buying more shares of the same stock or ETF. The practice is commonly known as a dividend-reinvestment plan (DRIP). It’s important to remember, however, that companies are not required to pay dividends, and those that are paying dividends now may choose to stop.
Some of the advantages and disadvantages of DRIP plans include:
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Pros:
• Many DRIPs offer a discount on share price between 1% to 10%.
• Many company DRIPs allow commission-free trades when you reinvest your dividends.
• Using a DRIP may allow you to take advantage of fractional shares.
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Cons:
• Using a DRIP means your cash is tied up.
• Reinvesting in one stock can increase your risk exposure.
• Putting your capital into more shares can mean less liquidity.
The Takeaway
ETFs provide a built-in way to add diversification through the basket of stocks they invest in. Even so, you may still want to consider how the ETF will fit into your overall plan.
While owning a dividend ETF may offer income and potential growth, it’s important to consider your overall portfolio allocation and diversification.
You can also find out quite a bit of information about a fund from its prospectus, which is filed with the Securities and Exchange Commission (SEC) and is available to every member of the public. The prospectus can give you information such as past returns, as well as what kinds of fees you can expect to pay when you invest in the fund. You should also be able to learn more about the fund’s investment strategy.
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FAQ
How much do dividend ETFs pay?
Payouts from a dividend ETF depend on the holdings in the fund. Some high-yield stocks might pay 10% or more, some are in the 3% to 4% range.
What is dividend yield?
Dividends can be expressed as a cash amount (e.g., 50 cents per share), or as the dividend yield, which is expressed as a percentage of the share price. So a 50-cent dividend on a $10 per share is a yield of 2%.
How long do you have to own shares of an ETF to get the dividend?
Generally, you have to buy shares on or before the ex-dividend date for the ETF (the same applies to owning a dividend-paying stock). If you purchase shares after “the ex-date,” you won’t get the next dividend payment. To get ordinary, i.e., non-qualified dividends, there’s no required holding period.
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