How Dividend-Paying ETFs Work

Basics

In the world of exchange-traded funds (ETFs), which are typically associated with index-tracking and growth investment strategies, many also offer opportunities for generating income through the ownership of dividend-paying stocks. The process involves the ETFs accumulating regular dividend payments from their stocks, subsequently disbursing these earnings to the ETF shareholders. The fund's management determines the distribution method, which can either be in cash or reinvested into the underlying ETF investments.

Schedule of Dividend Disbursements in ETFs

Similar to individual stocks, ETFs have specific ex-dividend, record, and payment dates to regulate dividend distribution. These dates are crucial in determining the recipients and the payout schedule. Notably, the timing of dividend payments deviates from that of the underlying stocks and varies across ETFs.

Illustratively, the widely-followed SPDR S&P 500 ETF (SPY) designates the third Friday of the last month in each fiscal quarter (March, June, September, and December) as its ex-dividend date. In cases where this day falls on a non-business day, the ex-dividend date shifts to the preceding business day. The record date precedes the ex-dividend date by two days. The SPDR S&P 500 ETF distributes dividends at the close of each quarter.

Each ETF defines its dividend schedule, which is information accessible to all investors through the fund's prospectus. Like individual company shares, an ETF's price often experiences a pre-ex-dividend rise, indicative of heightened buying activity, followed by a post-ex-dividend decline, as investors holding the fund before the ex-dividend date receive dividends, contrasting with those acquiring it afterward.

Cash Dividend Disbursement Process in SPDR S&P 500 ETF

Cash dividends are the chosen mode of payout for the SPDR S&P 500 ETF. As outlined in the fund's prospectus, all dividends from its underlying stock holdings are initially deposited into a non-interest-bearing account. When dividends are slated for distribution at the end of the fiscal quarter, the SPDR S&P 500 ETF withdraws the accumulated dividends from the non-interest-bearing account, allocating them proportionally to investors.

Conversely, some alternative ETFs may opt to temporarily reinvest dividends from underlying stocks into the fund's holdings until the scheduled cash dividend payment. This practice introduces a modest degree of leverage into the fund, potentially enhancing performance in bull markets (upward price trends) and marginally detracting from performance in bear markets (downward price trends).

Dividend Reinvestment Strategies in ETFs

In addition to cash distributions, ETF managers can reinvest investors' dividends back into the ETF, an alternative to cash payouts. This can be achieved by reinvesting in the ETF's underlying index on behalf of the shareholders. The outcome is essentially the same: a 2% dividend reinvestment can be received by an ETF shareholder, who may choose to sell the shares for cash. These reinvestments can be viewed as advantageous, eliminating trade fees for additional share purchases through dividend reinvestment. However, it's crucial to note that annual dividends received via reinvestment are taxable in the year they are received, despite the absence of a cash payout.

Tax Implications of Dividends in ETFs

ETFs are frequently considered preferable over mutual funds for managing the investor's income tax exposure. This advantage stems from ETFs' distinctive approach to capturing taxable capital gains. Despite this, it's crucial to note that ownership of dividend-yielding ETFs does not defer the income tax generated by the ETF's dividends in a given tax year. The taxation of ETF dividends parallels that of mutual funds, necessitating a comprehensive understanding of the associated tax implications.

Dividend-Paying ETFs Examples

Explore five well-received ETFs emphasizing dividends:

SPDR S&P Dividend ETF (SDY)

SDY stands out as an exclusive dividend ETF, tracking the S&P High-Yield Dividend Aristocrats Index. This index comprises companies from the S&P Composite 1500 with a remarkable track record of 20 consecutive years of increasing dividends, offering investors a perception of lower risk due to the consistent dividend payments.

Vanguard Dividend Appreciation ETF (VIG)

VIG follows the S&P U.S. Dividend Growers Index, featuring companies with at least ten consecutive years of dividend increases. With a domestic investment focus, the portfolio includes prominent dividend-paying entities like Microsoft Corp. (MSFT) and Johnson & Johnson (JNJ).

iShares Select Dividend ETF (DVY)

As the largest dividend-weighted ETF, DVY concentrates on domestic small-cap companies. Approximately one-quarter of its 100-stock portfolio consists of utility companies, while other major sectors include financials, consumer staples, energy, and communication stocks.

iShares Core High Dividend ETF (HDV)

HDV, a product of BlackRock's iShares, utilizes a smaller portfolio and tracks a Morningstar-constructed index of 75 U.S. stocks. Emphasizing dividend sustainability and earnings potential, HDV aligns with the principles of Benjamin Graham and Warren Buffett's fundamental analysis, mainly focusing on the concept of an "economic moat."

Vanguard High Dividend Yield ETF (VYM)

VYM, known for its cost-effectiveness, tracks the FTSE High Dividend Yield Index, prioritizing companies with very high dividends. This ETF is significant in the financial and consumer staples sectors, providing exceptional tradability across diverse investor demographics.

Other Income-Oriented Exchange-Traded Funds

Beyond the previously mentioned funds, various income-oriented ETFs adopt unique strategies to enhance dividend yield. For instance, the iShares Preferred and Income Securities ETF (PFF) focuses on selecting preferred stocks from U.S. companies. Given the bond-like behavior of preferred stocks, PFF and similar ETFs generally offer higher dividend yields compared to traditional common stock ETFs.

Real estate investment trust ETFs like the Vanguard Real Estate ETF (VNQ) follow publicly traded equity real estate investment trusts (REITs). Due to the inherent characteristics of REITs, these ETFs typically boast higher dividend yields than common stock ETFs. International equity ETFs, such as the WisdomTree Emerging Markets High Dividend Fund (DEM) and the First Trust Dow Jones Global Select Dividend Index Fund (FGD), concentrate on companies domiciled outside the United States known for above-average dividend payouts.

Conclusion

While ETFs are commonly associated with broad index tracking like the S&P 500 or Russell 2000, many are dedicated to dividend-paying stocks. Over the period from 1930 to 2020, dividends constituted an average of 41% of the stock market's total returns. A robust history of dividend payouts is a longstanding and reliable indicator of corporate profitability.