Shareholders receive dividends as a distribution of a company’s profits in one of two ways, as individual stocks or ETFs. Unlike individual stocks, ETFs pool together many dividend-paying stocks for a more diversified investment fund.
Dividends are typically paid quarterly, although some ETFs will pay dividends monthly, either in cash or reinvestment in more shares.
How do ETF dividends work?
ETFs pool the dividends of multiple individual stocks, paying you a collective sum from several sources. If a fund has 100 shares of a stock that pays $2 per dividend, the fund pays a total of $200 in dividends. The fund then distributes the $200 to shareholders in proportion to the shares you own. For example, let’s say an ETF has 100 available shares and you own two. Your dividends would be 2 percent of the ETF’s total payout.
Most ETFs pay dividends quarterly
ETFs often focus on specific sectors of the economy, like clean energy or real estate, for example, and some ETFs concentrate on a particular investment strategy. Dividend ETFs are one specific type of strategy with different variations. Some funds are growth ETFs, which focus on new companies that display the potential to grow.
High dividend yield funds are another type of fund that invests in stocks with above-average dividend payments. ETF funds with a history of high dividend payout are known as dividend aristocrats.
What types of dividends can an ETF pay out?
With ETFs, two types of dividends exist, qualified and non-qualified.
- Qualified dividends: Qualified dividends are taxed at the capital gains rate, meaning the amount of tax you pay on ETF dividends depends on your adjusted gross income and your taxable income rate. The ETF must own the stock for 60 days during 121 days. The 121 day period starts 60 days before the ex-dividend date (also known as the reinvestment date).
- Nonqualified dividends: Nonqualified dividends are payable on stocks held by the ETF for less than 60 days. Nonqualified dividends are taxed at your regular income rate. You can determine the amount of nonqualified dividends by subtracting the number of qualified dividends from the total dividends in the fund.
A dividend must be either a nonqualified dividend that's taxed at your regular income rate or a qualified income that qualifies for a capital gain tax.
What types of stocks are in dividend ETFs?
The stocks that are most likely to have dividends are stable large-cap companies. Large stable companies that don't experience considerable growth or major increases in share price will often pay dividends to shareholders instead.
How to invest in dividend ETFs
Investing in dividend ETFs is relatively easy. First, you need to find the dividend ETF you want to invest in. To do this, you should understand your investment objectives to determine what fund is the best for you.
Questions to consider when choosing an ETF include:
- What is the expense ratio of the fund?
- How often does the fund pay dividends?
- Are you interested in monthly or quarterly dividend ETFs?
- Do you want cash dividends or to reinvest shares?
- What are the past returns of the fund?
- What is the fund's risk profile? Are the fund's stocks small-cap (the riskiest), medium-cap, or large-cap (the safest)?
- Is the fund diversified? Can the fund withstand stock market volatility?
Once you've decided on the fund you want to invest in, you can buy shares of an ETF through an online broker with your brokerage account. There's no minimum buy-in requirement with dividend ETFs, so you can start investing at any time.
The actual process of buying shares in an ETF is reasonably straightforward. The most challenging step is deciding where you want to place your investment.
Do bond ETFs pay dividends?
Commonly referred to as fixed-income ETFs, bond ETFs pay interest rather than dividends. Bond ETFs are more liquid than individual bonds, but the amount of the coupon you receive each month as interest on the bond changes depending on the different maturity dates of the bonds in the fund.
What is an SEC yield?
ETFs use SEC yields to compare funds uniformly. The SEC yield formula is as follows:
Net 30-day income / share price at the end of the period.
The U.S. Securities and Exchange Commission created SEC yields as a uniform way to calculate ETF returns and is particularly useful when comparing funds to find a high-dividend ETF.
What are the pros and cons of dividend ETFs?
Pros: A dividend ETF diversifies your financial portfolio and allows you the potential to profit without having to worry about actively managing the fund.
Cons: You don’t have a say in the particular stocks that make up the fund, and you can’t change shares in the fund. This means the fund manager could sell stocks at a time that does not benefit you. ETF expense fees can also reduce the total returns you see on your investment.
Are dividend ETFs different from dividend mutual funds?
ETFs are traded like stocks throughout the day, while mutual funds’ values are determined at the end of a trading day, using net asset value (NAV) to calculate the price per share.
In both mutual funds and ETFs, you do not directly own shares of a company. Instead, the fund owns shares, and you own shares of the fund. This is why the fund will facilitate dividend payouts for you, rather than receiving dividends directly from the companies.
In most cases, a fund manager actively oversees mutual funds, while ETFs track index funds as a benchmark. Since ETFs are not managed as actively as mutual funds, they usually have a low cost compared to mutual funds. Like ETFs, mutual fund dividends are typically paid quarterly.
The bottom line
Dividend investing and ETF investing are investment strategies that you can combine into one. High-yielding ETFs allow you to diversify your financial portfolio at a low cost.
Remember, there are many factors to consider when investing in dividend ETFs, such as dividend yields, expenses ratios, market volatility, and timing of payments. Understanding each of these will help you invest wisely.
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