For public companies, one of the simplest ways to communicate financial stability to shareholders is through cash dividend payments. The most established companies often share a portion of their profits with investors, rewarding them with cash dividends. For investors, dividends provide a steady stream of passive income.
Owning dividend-paying companies through exchange-traded funds (ETFs) can be highly efficient. A dividend ETF is a fund that invests exclusively in dividend-paying companies. Fund managers select these companies based on specific attributes such as size, industry, geographic region, and dividend history. Next, they group them into a basket of holdings representing an investment category such as “dividend aristocrats.”
Once you select a dividend investment style, every holding in that ETF will have a similar profile.
For example, suppose you choose a fund that only invests in large-cap companies with a history of consistently paying dividends. In that case, a fund manager cannot deviate from that investment strategy. This principle is important as the investment style you choose will determine the varying degrees of risk and the potential returns.
For retail investors, ETFs are convenient because they provide instant diversification at a low cost. This added benefit makes dividend ETFs appealing to market participants, especially when picking stocks requires a certain level of investment knowledge.
Top dividend ETFs
Below are some of the most widely held dividend ETFs on the market.
Vanguard Dividend Appreciation ETF (VIG)
VIG tracks the performance of the NASDAQ U.S. Dividend Achievers Select Index. The investment strategy focuses on dividend growth, selecting companies that have consistently increased dividend payments for at least a decade.
Fund’s dividend yield: 1.7 percent
Top holdings: Microsoft (MSFT), JPMorgan Chase (JPM), and Johnson & Johnson (JNJ)
Expense ratio: 0.06 percent
Assets under management: ~$62 billion
Vanguard High Dividend Yield ETF (VYM)
VYM tracks the performance of the FTSE High Dividend Yield Index. The index selects high-yield dividend-paying companies based in the U.S., excluding REITs (real estate investment trusts).
Fund’s dividend yield: 2.8 percent
Top holdings: JPMorgan Chase (JPM), Johnson & Johnson and Home Depot (HD)
Expense ratio: 0.06 percent
Assets under management: ~$39 billion
SPDR S&P Dividend ETF (SDY)
SDY tracks the performance of the S&P High Yield Dividend Aristocrats Index. The index screens for companies that have consistently increased dividend payments for at least 20 consecutive years.
Fund’s dividend yield: 2.6 percent
Top holdings: AT&T (T), Exxon Mobil (XOM) and Chevron (CVX)
Expense ratio: 0.35 percent
Assets under management: ~$19 billion
iShares Select Dividend ETF (DVY)
DVY tracks the performance of the Dow Jones Select Dividend Index. The index selects high-dividend yield companies — about 100 of them — based in the United States.
Fund’s dividend yield: 3.3 percent
Top holdings: Altria Group (MO), ONEOK (OKE), and AT&T (T)
Expense ratio: 0.38 percent
Assets under management: ~$18 billion
ProShares S&P 500 Dividend Aristocrats ETF (NOBL)
NOBL tracks the performance of the S&P 500 Dividend Aristocrats Index. The index screens for multinational household names with a history of increasing dividends for at least 25 years, with some of them doing so for more than 40 years.
Fund’s dividend yield: 2.0 percent
Top holdings: Nucor (NUE), Albemarle (ALB) and West Pharmaceutical Services (WST)
Expense ratio: 0.35 percent
Assets under management: ~$9 billion
How dividends work
Dividend payments are usually issued to shareholders every quarter, although, in some cases, there can be special dividends that act as a one-time bonus. To be entitled to an upcoming dividend, a shareholder must own a company’s stock up to and including what’s known as the ex-dividend date.
Investors pay particular attention to the dividend yield, highlighting how much a company or fund pays in relation to its stock price. Dividend yields are calculated by taking the annual dividend payment and dividing it by the share price. The yield is shown as a percentage. Yields may be calculated based upon payments made over the last year or payments expected to be made over the next year.
For example, if a company’s annual dividend payment is $4 and the share price is $100, you would see a dividend yield of 4 percent with a quarterly distribution of $1.
To be sure, a high yield doesn’t always mean a solid investment opportunity. Indeed, many investors view the highest yields as a red flag as a company’s shares might have taken a hit, causing yields to rise. Or, perhaps, a company may be trying to lure investors with high yields.
As a rule, be sure to look at a company’s entire financial picture before investing. A dividend payment is just the icing on the cake.
How to invest in dividend ETFs
A solid dividend strategy is an essential component of every investor’s portfolio. Since the 1930s, dividends have accounted for 41 percent of the S&P 500’s total returns, according to research by Hartford Funds. And when dividends are reinvested, the returns are even higher, accounting for 84 percent of the S&P’s total returns since 1970.
Inherently, dividend investing tends to be less risky. Companies in a position to issue regular payments are often more cash-rich than those trying to rapidly grow their businesses. Well-established names also have a history of boosting their dividend payouts every year and take a lot of pride in doing so.
When choosing dividend ETFs, here are four steps to consider:
- Determine your financial goals: The type of investments you choose depends on what you are trying to achieve. For example, someone about to retire will likely have a more conservative approach to investing. So always let your financial objectives drive your decision-making.
- Research dividend funds: When selecting dividend ETFs, pay attention to factors like dividend history, dividend yield, the fund’s performance, expense ratios, top holdings, and assets under management. Investors can find this information in a fund’s prospectus.
- Outline your asset mix: Before investing, do an inventory of what you own and how you want to allocate your assets. Remember, the key is to remain diversified.
- Know what you own: By periodically reviewing your investments, you can take charge of your finances and make any adjustments needed. Leverage any free resources from your broker, like meeting with a financial planner, and always ask questions. Ultimately, there’s no such thing as a hands-off investment.
Like any other investment, dividend ETFs are susceptible to losses. The magnitude of potential losses is tied to the level of risk contained in the portfolio. So a fund that invests heavily in potentially riskier assets like companies in emerging markets will have a very different risk profile than a fund that invests in established, tried-and-true names. Macroeconomic factors like the interest rate environment also play a factor.
Are dividend ETFs a good investment for you?
An investment approach focused on dividends can make sense for many people at different stages of their investing lives. Dividends can be a great way to build wealth over time, as growing companies distribute earnings to their shareholders. Dividends also make sense for those looking to generate income from their investments, such as those who have reached retirement age. Always think about your financial goals and consider whether dividend ETFs can help you achieve them.
What to look for in a dividend ETF
Here are some things to consider when choosing a dividend ETF:
- Fees: You’ll want to understand the ETF’s expense ratio before making an investment. Some ETFs have very low fees, while others can run higher and eat into your returns.
- Yield: Pay attention to a dividend ETF’s yield to understand what kind of income you can expect to earn over the next year. Remember that future dividends aren’t guaranteed, but a yield will give you an idea of what to expect.
- Liquidity: Some ETFs might have less liquidity than the more popular funds offered by major ETF managers. When the time comes, this could make it harder to sell.
- Portfolio makeup. Keep an eye on the fund’s holdings and see if it has a lot of exposure to certain companies or industries. If a fund has significant exposure to one industry, you likely won’t get the diversification benefits offered by other funds.
How are dividends taxed?
Depending on the type of investment account you own, dividend distributions are taxed as regular income or at a reduced rate under special considerations. These rules only apply for holdings outside tax-advantaged accounts like a 401(k) or an IRA, where you won’t pay taxes on dividends or capital gains.
The bottom line
History shows that dividends have been a significant source of income for investors. When consistent dividend payments and rising stock values are combined, they can be a powerful wealth-building tool.