There’s no doubt that dividend-paying assets are popular investment choices. Investors tend to favor dividends in order to stabilize a portfolio, minimize some risk, hedge against inflation or even create a revenue stream. And in order to accomplish these goals, traders can utilize, stocks, mutual funds and even dividend ETFs.
However, dividend ETFs work a little differently than other investment products, so it’s important to understand the differences.
What is a Dividend ETF?
A dividend ETF consists of dividend-paying stocks and usually tracks a dividend index. The stocks in the fund or index are selected based on their dividend yield. Some ETFs apply a general dividend strategy that covers the market as a whole, or they can be segmented.
For example, there are some dividend ETFs that are based on the market capitalization of the included stocks and there are some that are based on location such as a country-specific dividend ETF or an emerging market dividend ETF.
How Are the Dividends in a Dividend ETF Paid?
Like a mutual fund or stock, the dividend is credited right into your brokerage account. However, there are some dividend plans that reinvest the dividend back into the asset.
For example, with a mutual fund, the dividend can be used to buy more shares of stock in the fund. Usually there is no brokerage fee for purchasing the shares.
However, in the case of a dividend ETF, the dividend is used not to buy shares of stock in the fund (since an ETF is pre-packaged), but it’s used to buy more shares of the ETF. The downside to this is that there may be a brokerage fee on the buy transactions.
How Are the Dividends Taxed?
The dividends from an ETF are taxed, but the tax rate is based on whether the dividend is classified as qualified or unqualified. A qualified dividend is determined by a set of criteria such as the length of time an asset is held.
An unqualified dividend is a dividend that the government does not consider a true dividend such as dividends on money market accounts, dividends on short term mutual fund capital gains, interest from your credit union, dividends in your IRA, and dividends from REITs. These are taxed at the normal tax rate.
What Are the Advantages of a Dividend ETF?
As we said above, there are a few reasons to consider dividend ETFs. They create a revenue stream, at times people consider them safer than other investments, diversification, stability, and to hedge risk and inflation.
What Are the Disadvantages of ETFs?
While people consider dividend assets as a hedge against inflation, sometimes dividend yields do not outperform the inflation rate and therefore aren’t actually hedging the risk.
Also, dividend-paying companies can choose to cut their dividend or eliminate it all together.
One way some dividend ETFs and indexes hedge against a decrease in dividend is to select stocks that have been paying dividends for a long time or have a stable dividend yield.
Which Dividend ETF Should I Choose?
That depends on a lot of factors – risk tolerance, financial goals, your portfolio, etc. I can’t give you that answer. However, I can give you a list of dividend ETFs that you can research and decide which is the best for your investment strategy.