How Do ETF Dividends Work?

One of the ways that investors make money from exchange traded funds (ETFs) is through dividends that are paid to the ETF issuer and then paid on to their investors in proportion to the number of shares each holds.

If you're looking for an ETF that pays a steady stream of income, you might consider one of the many ETFs that focus on investments that historically have paid high dividends.

ETF issuers decide whether to pay these dividends directly or reinvest them in the fund. The fund prospectus makes it clear which it is.

The Timing of ETF Dividend Payments

Like any company that issues a stock dividend, an ETF's sponsor sets an ex-dividend date, a record date, and a payment date. These dates determine who will receive the dividend and when it will be paid. The timing of these dividend payments is on a different schedule than those of the underlying stocks and is set by the ETF sponsor.

For example, the ex-dividend date for the popular SPDR S&P 500 ETF (SPY) is the third Friday of the final month of a fiscal quarter (March, June, September, and December). If that date is not a business day, the ex-dividend date falls on the prior business day. The record date comes two days prior to the ex-dividend date. At the end of each quarter, the SPDR S&P 500 ETF distributes the dividends.

These dates are listed in the fund's prospectus, which is publicly available to all investors.

Just as like any stock shares, the price of an ETF often rises before the ex-dividend date—reflecting a flurry of buying activity—and falls afterward, as investors who own the fund before the ex-dividend date receive the dividend, and those buying afterward do not.

Dividends Paid in Cash

The SPDR S&P 500 ETF pays out dividends in cash. According to the fund’s prospectus, the SPDR S&P 500 ETF puts all dividends it receives from its underlying stock holdings into a non-interest-bearing account until it comes time to make a payout. At the end of the fiscal quarter, when dividends are due to be paid, the SPDR S&P 500 ETF pulls the dividends from the non-interest-bearing account and distributes them proportionally to the investors.

Some ETFs may temporarily reinvest the dividends from the underlying stocks into the holdings of the fund until it comes time to make a cash dividend payment. Naturally, this creates a small amount of leverage in the fund, which can slightly improve its performance during bull markets and slightly harm its performance during bear markets.

Dividends Reinvested

ETF managers also have the option of reinvesting investors' dividends into the ETF rather than distributing them as cash. The payout to shareholders is accomplished through reinvestment in the ETF's underlying index on their behalf.

Essentially, it comes out to the same amount: An ETF shareholder who receives a 2% dividend reinvestment from an ETF can sell those shares and take the cash.

Dividends Are Taxable

These reinvestments can be seen as a benefit, as it does not cost the investor a trade fee to purchase the additional shares through the dividend reinvestment.

However, each shareholder's annual dividends are taxable in the year they are received, even if they are received via dividend reinvestment.

Taxes on Dividends in ETFs

ETFs are often viewed as a favorable alternative to mutual funds in terms of their ability to control the amount and timing of income tax to the investor. However, this is primarily due to how and when the taxable capital gains are captured in ETFs.

Owning dividend-producing ETFs does not defer the tax on the dividends paid by an ETF during a tax year. The dividends that an ETF pays are taxable to the investor in essentially the same way as the dividends paid by a mutual fund are taxable.

Examples of Dividend-Paying ETFs

Here are five popular dividend-orientated ETFs.

1. The SPDR S&P Dividend ETF (SDY)

The SPDR S&P Dividend ETF (SDY) is the most extreme and exclusive of the dividend ETFs. It tracks the S&P High-Yield Dividend Aristocrats Index, which includes companies in the S&P Composite 1500 that have increased their dividends for at least 20 consecutive years.

Due to their long history of reliably paying these dividends, these companies are often considered less risky for investors seeking total return.

2. The Vanguard Dividend Appreciation ETF (VIG)

The Vanguard Dividend Appreciation ETF (VIG) tracks the S&P U.S. Dividend Growers Index, a market capitalization-weighted grouping of companies that have increased dividends for a minimum of ten consecutive years.

Its assets are invested domestically, and the portfolio includes many companies known for paying rich dividends, such as Microsoft Corp. (MSFT) and Johnson & Johnson (JNJ).

3. The iShares Select Dividend ETF (DVY)

The iShares Select Dividend ETF (DVY) is the largest ETF to track a dividend-weighted index. Similar to VIG, this ETF invests in U.S. companies but the focus is on smaller companies.

Roughly one-quarter of the 100 stocks in DVY's portfolio are utility companies. Other major sectors represented include financials, consumer staples, energy, and communication stocks.

4. The iShares Core High Dividend ETF (HDV)

BlackRock's iShares Core High Dividend ETF (HDV) is younger and uses a smaller portfolio than the company's other notable high-yield option, DVY. This ETF tracks a Morningstar-constructed index of 75 U.S. stocks screened by dividend sustainability and earnings potential, which are two hallmarks of the Benjamin Graham and Warren Buffett school of fundamental analysis.

In fact, Morningstar's sustainability ratings are driven by Buffett's concept of an "economic moat" that some businesses create to insulate themselves from their rivals.

5. The Vanguard High Dividend Yield ETF (VYM)

The Vanguard High Dividend Yield ETF (VYM) is characteristically low-cost and straightforward, like most Vanguard offerings. It tracks the FTSE High Dividend Yield Index effectively and demonstrates outstanding tradability for all investor demographics.

A particular quirk of the investment strategy for VYM is its focus on companies that pay very high dividends. As a result, this ETF's majority holdings are heavy in the financial and consumer staples sectors.

Other Income-Oriented ETFs

In addition to these five funds, there are dividend-focused ETFs that employ various strategies to increase dividend yield.

ETFs such as the iShares Preferred and Income Securities ETF (PFF) track a basket of preferred stocks from U.S. companies. The dividend yields on preferred stock ETFs should be substantially more than those of traditional common stock ETFs because preferred stocks behave more like bonds than equities and do not benefit from the appreciation of the company's stock price in the same manner.

Real estate investment trust ETFs such as the Vanguard Real Estate ETF (VNQ) track publicly traded equity real estate investment trusts (REITS). Due to the nature of REITs, the dividend yields tend to be higher than those of common stock ETFs.

There are also international equity ETFs, such as the WisdomTree Emerging Markets High Dividend Fund (DEM) or the First Trust Dow Jones Global Select Dividend Index Fund (FGD), which track higher-than-normal dividend-paying companies domiciled outside of the United States.

The Bottom Line

Although ETFs are best known for tracking broad indexes such as the S&P 500 or the Russell 2000, many ETFs focus on dividend-paying stocks.

Historically, dividends have accounted for about 41% of the total returns of the stock market, and a strong dividend payout history is one of the oldest and surest signs of corporate profitability. If your goal is steady income, you might look at one of the many ETFs that focus on dividend-paying companies.