ETFs, or exchange-traded funds, are “baskets” of securities sold in shares, just like stocks. The difference is, with an ETF, you’re purchasing partial shares of dozens to hundreds of stocks.
Imagine a lasagna. You have multiple layers of noodles, cheese, and filling stacked on top of each other. Come dinnertime, when you cut a slice, you get a little bit of everything on your plate. ETFs “stack” securities in a similar fashion.
Many ETFs track specific indices, which means they fill their basket with stocks or bonds included in a particular index. Additionally, these ETFs often maintain a minimum percentage of securities from these indices, often ranging from 80% to 90%. ETFs may also follow industry sectors or market capitalization.
There are many types of ETFs available on the market to cater to a wide variety of financial needs. Some focus on income generation, offsetting investment risks, or a specific type of security. Some common ETFs include:
- Bond ETFs, which track various government-sponsored bonds
- Commodity ETFs, which invest in gold, crude oil, or other physical commodities
- Inverse ETFs, which attempt to increase gains by shorting the stocks in their basket
- Dividend ETFs, which seek to maximize dividend yields so as to produce steady income
This last type of ETF is what we’re going to focus on in this article.
Dividend ETFs focus on bringing in income through dividend returns. These passively managed funds usually have low expense ratios while providing higher dividend payments than other types of ETFs.
You can divide dividend ETFs into several categories.
- Dividend aristocrat ETFs, which have consistently raised dividend payments for 25 consecutive years or more
- High vs low yield ETFs; high-yield ETFs pay more but come with higher risks, while low-yield ETFs pay less but are usually more stable
- Domestic vs international ETFs; while domestic ETFs invest in companies that have home bases in the United States, international ETFs look beyond our borders for potentially valuable investments
- Quarterly vs monthly payment ETFs, which pay dividends four or twelve times per year, respectively
As with all ETFs, dividend-focused funds come with several benefits, as well as a few risks. Dividend ETFs allow investors to predictably supplement their annual income with dividend payments. This makes them ideal for hedging against low-rate or highly volatile markets.
Because most of these funds are passively managed, less is lost to administrative and managerial fees over time. ETFs also allow investors to diversify their holdings with just a few shares, rather than forcing investors to spend hundreds on a single share of one company.
However, because you’re purchasing a pre-determined basket of securities, your payments are a blended yield, rather than a percentage yield proportional to how much of any one security you own. This means that even a single company lowering or nixing its dividends within the fund may adversely affect your dividend payment.
Furthermore, just because an ETF pays a dividend doesn’t mean that that dividend will be worth the cost of entry in the long run. As with any investment, it’s important to research past performance and current holdings to get an idea of if the fund may pay off in the future.
What is a Dividend ETF?
Dividend ETFs are a type of ETF that focus on gains, specifically by selecting securities that pay dividends to investors. Often, these include common and preferred stocks as well as real estate investment trusts, or REITs. Additionally, these types of ETFs may contain either or both domestic and foreign investments, depending on the underlying index.
Many dividend ETFs are passively managed, which reduces administrative fees and increases returns. Passively managed funds typically follow a particular index to reduce the need for human mediation.
Frequently, fund managers for these ETFs weed out securities from the underlying index that don’t match the funds goals in order to streamline investments. They may also handpick a few securities to add to the fund, such as companies with a history of raising dividends or lower-risk blue chip companies.
Typically, dividend ETFs are recommended for risk-averse, income-oriented investors. The key is to choose funds that also have low expense ratios, which means you lose less of your profit to the fund manager.
Types of Dividend ETFs
While there are no static metrics for determining types of dividend ETFs, there are a few ways to categorize them. We’ll cover some of these here.
Dividend Aristocrat ETFs
This type of ETF is what investors think of when they’re considering high-yield securities. Dividend aristocrat stocks are members of the S&P 500 that have increased their annual dividend payments every year for a minimum of 25 consecutive years.
These companies all have individual market capitalizations of $3 billion or more and a history of steady cash flow. Some – but not all – of these companies are also “blue chip” companies, or companies that dominate their respective markets and are well-established.
While dividend aristocrat ETFs typically follow the underlying S&P 500 Dividend Aristocrat index, fund managers may also handpick a selection of outside stocks. This in turn can help bolster returns or further spread risk across securities.
High-Yield vs Low-Yield Dividend ETFs
When you’re looking for dividend ETFs, you can either look for incredibly high yields or potentially stabler, lower yields. Higher-yield securities often come with more risks, such as the issuing company cutting dividend payments or floundering through financial distress. For some investors, the higher payoffs are worth the risk; for others, lower, predictable yields are preferable.
With higher-yield dividend ETFs, there are a few ways a fund may increase its payout. For instance, some funds pay only average to slightly-higher-than-average returns but mitigate by offering rock-bottom expense ratios. Others may have slightly higher expense ratios but counteract with better yields.
While it may seem counterintuitive to the strategy, there are cases where owning low-yield dividend ETFs may make sense. For instance, some ETFs – and their underlying indexed companies – may provide low yields because they’re rerouting capital back into developing the firm. This may hint toward future earning potential and capital gains, which can be valuable come tax time.
Furthermore, some dividend ETFs that post lower yields may be more stable than their high-yield counterparts. While every investor wants to see a return on their investment, doing so at a higher risk of losing their capital isn’t worth it for every. Some investors, then, prefer to stick to dividend ETFs that consistently generate returns through solid holdings.
On the other hand, if an ETF consistently posts low dividends that seem counterintuitive to its mission statement, it could be a sign of trouble in underlying securities. This may be the result of instable cash flow, shaken investor confidence, or even bankruptcy. Once even a single security in an ETF experiences financial issues, it threatens the stability of the fund’s dividends.
Domestic vs International ETFs
Many investors throw their money into the market with a “home country” bias – that is, they only invest in companies that operate within domestic borders. Some larger companies, such as Apple and Starbucks, do operate both domestically and internationally, but they still count as domestic ETFs for all intents and purposes.
Moving beyond the boundaries of your home country and investing in companies that originate and operate primarily from another continent is one way to diversify your investment portfolio. This can help protect against the ups and downs of national financial cycles. Just because the market is crashing in the United States doesn’t mean that European or Asian markets experience the same downturn. By increasing exposure, investing in international dividend ETFs can actually reduce your overall risk in the market.
However, that’s not to say international investments carry no risk. Political movements, currency volatility, and less transparent regulation are all risks that domestic funds don’t carry in the same way. Therefore, if you decide to broaden your dividend ETF horizons beyond your usual borders, it’s usually advised to seek out a firm or advisor who specializes in this type of portfolio rebalancing.
Quarterly vs Monthly Payment Dividend ETFs
As with most securities, ETFs tend to pay out dividends quarterly, or four times per year. This means that investors can look forward to receiving one-fourth of their annual return every three months. While owning one or two shares of an ETF may not earn much in the course of three months, the more you own, the more money you make. This is why “living off your dividends” is still a realistic goal in the investing world.
However, some ETFs have emerged in recent years with the promise of monthly payments instead. These offer benefits in terms of ease of accounting, as well as the ability to rely on steady, monthly cash flow. Furthermore, the ability to count on dividends in your monthly income can be helpful in allotting money toward bills and regular payments.
Additionally, if such monthly dividends are reinvested rather than spent, they tend to yield greater total returns over time. This is the result of compounding your interest – putting your interest back into the fund as principle, which then earns even more interest.
Benefits of Dividend ETFs
Investing with dividends in mind is one of the strategies employed by income-oriented investors. As with all investing strategies, this method employs some risk, but also some unique advantages.
For instance, dividend ETFs are one way to supplement your monthly or annual income. Whether you use this money for immediate needs or to reinvest in your assets, such returns are a big component in why people invest in dividend ETFs.
Additionally, many dividend ETFs have lower expense ratios compared to actively managed funds. This further boosts profits while minimizing liabilities and losses.
Dividend ETFs are also one way for investors to protect themselves in highly volatile markets, as well as low-rate environments. In times of economic instability, ETFs that guarantee dividends – especially those with higher-than-average dividends – provide safe haven against the financial storm.
Furthermore, ETFs of any kind are an excellent way to diversify your portfolio. Purchasing even a single share of an ETF exposes your portfolio to dozens – if not hundreds – of securities in one go. This act alone can help reduce volatility, increase stability, and even the playing field within your portfolio.
Risks of Dividend ETFs
However, dividend ETFs are not without their risks. For one, because you’re investing in a pre-determined basket of securities, you end up with a blended yield of whatever’s inside the basket. This means that, if one company increases its dividend while another decreases, you don’t benefit evenly. You’ll receive a blend or an average of the new yields.
Furthermore, not all dividend-paying ETFs generate high returns, especially when inflation and management fees are taken into account. Just because an ETF pays a dividend doesn’t mean that you’ll come out on top every time. The best way to combat this risk is through thorough research of your potential investments. It’s important to look at past performance and holdings as well as current returns. This will give you an idea of how the fund may operate in the future.
Looking for a hands-free approach to investing? Download Q.ai Invest and let AI manage your money with institutional-grade, AI-powered investment strategies – totally commission-free.