Exchange-traded funds (ETF) generally offer two strategies for investing. One approach emphasizes traditional capital gains growth. As products listed on an exchange, ETFs are highly liquid assets. You can buy and sell them like ordinary stocks, and collect the difference when their value grows. The other strategy emphasizes income investing. The ETF will pay dividends based on the collection of stocks in its portfolio. You can collect these dividends the same way you would with a bundle of stocks, and choose whether to focus on trading the ETF or holding it for the long run.
A financial advisor can walk you through your options and help you decide which type of ETF or other security best fits your goals, timeline and risk profile.
How Do ETF Dividends Work
An ETF is a fund-based product, meaning that it holds a collection of different assets in a single portfolio. Investors buy shares of this overall investment portfolio and collect a return based on their proportional ownership of the fund.
Most ETFs hold a large cross-section of assets that heavily include stocks (indeed, funds that emphasize growth investing may focus their portfolio on equities). When those stocks pay out dividends, the ETF will typically do one of two things:
Reinvestment
The ETF will roll dividend payments into the fund itself, using that income to buy new assets. Often the fund will buy the same stock that paid out the dividend, a strategy generally known as “dividend growth investing.” Investors in the ETF see the value of their own investment grow proportional to the number of shares they own. That is to say, this approach increases the value of the ETF itself which, in turn, increases the value of each of its shares.
Payment
The ETF will take dividend payments made by its underlying stocks and distribute them as a direct payment to shareholders. This is considered a dividend payment by the ETF itself, as shareholders receive payment based on the overall amount of dividends paid by the fund’s assets.
Timing and Structure of ETF Dividend Payments
When an ETF pays dividends it does so based on the total value of dividends the fund collected from its stocks, divided among the number of shares the ETF has distributed. For example, say that an ETF issues 100 shares in the overall portfolio. The fund holds stock in ABC Corp. and XYZ Corp. These companies issue a dividend payment of $1 per share and $3 per share, respectively. The ETF would collect a dividend of $1 per share that it holds in ABC Corp. and $3 per share in XYZ Corp. It would then divide this money among the 100 shares that the fund has issued.
Dividend payments are not averaged between the publicly traded corporations in an ETF portfolio. They are additive. This is as opposed to the way in which the fund’s overall value is measured, which is the average value of the fund’s assets.
An ETF does not pay dividend payments as it receives them. Instead the rate and timing of ETF dividend payments are up to the individual fund. The fund will collect payments over time, holding them in an account, then issue those payments in one lump sum on its own schedule. Most funds pay their dividends on either an annual or a quarterly basis.
Investors must own their qualifying shares of the ETF by the fund’s dividend record date in order to receive a payment, and so must purchase their shares by the ex-dividend date in order to record their ownership in time. Standard U.S. stock exchanges have a two-day lag between when you buy a stock and when the transfer is recorded. This means that in order to own the stock on the dividend record date, you must issue the purchase order at least two business days in advance. The day before the record date is known as the “ex-dividend date,” or the date on which anyone who purchases new shares of the ETF will not receive the right to collect its dividend payment.
An ETF can issue two types of dividend payments based on the tax status of its holdings:
Qualified Dividends
This type of payment qualifies to be treated as capital gains for income tax purposes. This is determined based on how long the ETF has held the underlying stock, and based on how long you have held your shares of the ETF.
To be eligible for qualified dividend status the ETF must have held the underlying stock for at least 61 days out of the 121-day period which began 60 days before the stock’s ex-dividend date. In addition, you must have held your shares in the ETF for at least 61 days out of 121-day period which began 60 days before the ETF’s ex-dividend date.
Non-Qualified Dividends
These are dividends that do not meet the holding requirement for qualified status. The dividends paid by highly active ETFs (ones which trade frequently to maximize capital gains) and those collected by highly active traders are likely to be mostly non-qualified.
Non-qualified dividends are taxed as ordinary income.
Finally, investors should remember that not all ETF yields count as dividends. Only payments based on underlying stock dividends count as ETF dividends. Other payments, such those generated by interest payments from underlying assets, will not count as ETF dividend payments.
The Bottom Line
ETF dividends are payments that the fund makes when it, in turn, receives dividend payments from stocks that it holds. The ETF distributes these payments on its own timeline, holding the payments from all of its underlying stocks until it’s time to pay shareholders. Payments can be made in cash or as purchases of the fund’s underlying equities. Dividend-oriented ETFs generate these payments by holding various types of securities: common stock; preferred stock; real estate securities; and non-U.S. equities.
Tips on Investing
- Dividend-bearing stocks are a strong choices for income investors. While higher risk than other income investments, most particularly the interest payments generated by bonds, they can be an excellent way to build your portfolio over time.
- Should you invest in an ETF? Or should you directly invest in the dividend-bearing stocks themselves? Such questions are best tackled with the insights of a financial advisor, and finding one doesn’t have to be hard. SmartAsset’s matching tool can help you find a financial professional in your area, within minutes, to help you make these decisions. If you’re ready, get started now.
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