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Do ETFs pay dividends?

If you have explored the world of ETF investing, you may have come across funds that end with ‘ACC’, and funds that end with ‘DIST’. If the ETF includes ‘ACC’ after its name, it is an accumulating ETF, and if the ETF says ‘DIST’ it is a dividend distributing ETF. These are the two ways of handling dividends and coupon payments associated with ETF investing.   

The first strategy focuses on accumulation and traditional capital gains growth. As ETFs are listed on an exchange, they are considered highly liquid assets. They can be bought and sold just like regular stocks, and profit from the difference when their value increases.   

In other words, dividends are not paid on accumulation ETFs; instead, the earnings are reinvested, which causes the price of the ETF to rise. These are an excellent choice if your goal is to maximize your future investment returns, as they automatically reinvest your profits back into the fund at no extra expense. This saves you time, compounds your returns, and reduces trading expenses.  

The second strategy focuses on income investing. Income ETFs pay out dividends to investors in cash, based on the stocks in the ETF’s portfolio. The investor can then collect these dividends and choose whether to trade the ETF or retain it for the long term.  

A dividend ETF owns shares in high-paying dividend companies. These are companies that pay out profits to their shareholders either, quarterly, every six months or annually through cash or stock payments.  

Some of the pros of dividend ETFs normally include a greater quality of portfolio (value stock) and the ability to generate a regular stream of income. Some of the cons include the fact that there is no guarantee of future dividends, that stock prices decline and offset the yield, and that the dividends are highly taxed.  

Dividend-paying ETFs are becoming increasingly popular, particularly among investors seeking high yields and greater portfolio stability. According to Morningstar, there are 134+ dividend ETFs, which have attracted $140 billion in new money during the last decade. This isn’t surprising, as interest rates have been decreasing, and demand for stable sources of investment income has risen as the first wave of baby boomers begin to retire.

Different types of dividend ETFs  

Dividend ETFs are divided into several categories, including index funds, geographies, and equities with historically increasing dividends, such as dividend aristocrats.   

Other forms of dividend ETFs include sectors such as real estate (REITs), which are noted for their high yields. A few more examples include diversified high dividend ETFs and international diversified high dividend ETFs.  

With so many dividend ETFs to choose from, it’s crucial for investors to recognize that they’re not all created equal. Each one has its own unique characteristics, which stems from crucial—yet often nuanced—differences in the strategies of the indexes that underpin them.  

By understanding three essential aspects of these funds, investors will be able to make informed financial decisions. These are: Dividend yielddividend growth, and dividend durability.  

Dividend yield

The current dividend yield of a fund is often the first indicator investors look at when considering dividend-producing ETFs. This is the amount of money paid in dividends over the previous year as a percentage of the purchase price. For example, the dividend yield of an ETF costing $100 – which pays out $10 in dividends – will be 10% p.a.  

ETFs that emphasize higher-yielding stocks and stocks with a shorter dividend history are often come with more risk. A high dividend yield may suggest that the market has lost faith in a company’s prospects and is doubtful of its ability to keep its pay-out at its current level.  

Dividend growth

Dividend yields are often viewed in isolation by investors, who fail to recognize the importance of dividend growth. A company’s current dividend payment does not guarantee that it will continue to do so in the future. Even if it maintains its dividend, there’s no assurance that it will increase over time.   

This is why some investors prefer to invest in “dividend aristocrats”, which are S&P 500 firms that have a lengthy history of increasing their dividends over time.  

Dividend growth is a crucial part of the entire income equation since it determines whether an investor’s income will fall behind, keep up with, or outpace inflation. Of course, the idea is to expand this revenue stream faster than inflation in order to increase one’s actual income.  

Dividend durability

This refers to the quality of the stock and the creditworthiness of the ETF’s holdings. If the fund owns a lot of risky firms, the fund’s value will likely fall, and your total return will fall with it.   

As a result, you may want to avoid funds that use risky firms to enhance their dividend yield and focus on funds that may give higher overall returns when dividends and stock price growth are taken into account.  

Just like dividend growth, the durability of firms’ dividends reflects the quality of its franchises, the stability of its cash flows, and ultimately, its capacity to repay capital to shareholders in the form of dividends even when the economy is in a downturn.

Factors to consider when choosing dividend ETFs

The cash flows provided by dividend ETFs are appealing to many investors. Nevertheless, other people may feel that a company’s true value is determined by its capacity to repay profits to shareholders in the form of dividends. It’s critical to grasp what dividend ETFs have to offer and what to be mindful of when you’re making decisions about your portfolio.  

Along with yield, growth, and durability, it is important that an investor considers the following factors associated with investing in dividend ETFs.  

When does the ETF distribute dividends?

ETFs don’t pay dividends as they are received; rather, the timing and rate of the dividend payments are left to the discretion of each fund. The fund accumulates the dividends over time, deposits them in an account, and then distributes them in one big sum in accordance with its own schedule. The majority of funds pay dividends on an annual or quarterly basis.  

ETFs that hold stocks tend to pay dividends once a year, whilst ETFs holding bonds tend to pay dividends monthly.   

Monthly dividends are very convenient for budgeting, managing cash flows, and providing a predictable income stream. Furthermore, if the monthly dividends are reinvested, these products provide higher overall returns.  

In order to receive a pay-out, investors need to own their qualifying shares of the ETF by the fund’s dividend record date, which means they must buy their shares before the ex-dividend date.  

Taxes

The tax implications of ETF dividends are determined by whether they are qualified or unqualified dividends.   

If they’re qualified dividends, they’ll be taxed at a rate ranging from 0% to 20%. If the dividends are unqualified, they will be taxed at your regular income rate. If you’re investing in an ETF that holds stocks, for example, then you will want to make sure it’s paying qualified dividends.  

Importantly, some countries charge a dividends tax when dividends are paid out, as well as a capital gains tax when stocks are sold. In these countries, those investing in accumulating funds will only have to pay a capital gains tax when the fund is sold.   

As a result, the accumulating fund would receive more capital, resulting in stronger compound effects and higher returns than a comparable distributing fund that would be taxed on its dividends.  

However, not all countries provide accumulating funds with this tax benefit. The United Kingdom is a prime example of this. On the other hand, Germany recently adjusted its tax system so that accumulating and distributing funds are taxed at the same rate, but overall, there are still additional compounding benefits that come with holding accumulating funds.  

It is also important to note that US-domiciled ETFs are required by US fund regulations to transfer at least 90% of its revenue to owners. Non-US domiciled funds and ETFs are not subject to the same restrictions, and they can reinvest profits and interest without having to distribute them, depending on the legislation of the nation in which they are domiciled. Accumulation ETFs are not as easily accessible regarding US-domiciled ETF investing.  

It is advisable that you become acquainted with the tax systems, as different countries have different tax policies.   

However, disregarding any local tax advantages, when two ETFs have the same assets and the only difference is that one is distributing and the other is accumulating, the long-term performance of the two will be the same.  

Transaction costs

You may have to pay transaction costs if you want to reinvest your dividends into distribution funds. You won’t have to pay anything for accumulating funds because the dividends are immediately reinvested without having to go through your brokerage account.  

This isn’t an issue if you invest in a fund that doesn’t impose transaction costs when you buy more shares, and only a tiny issue if you reinvest in the same fund on a regular basis (e.g. monthly), as you would simply add the dividend amount to your deposit because you’d be paying fees anyway.  

Should you invest in dividend ETFs?

Ultimately, it depends on the type of investor you are, the stage of life you’re in, where you live, your liquidity needs, and much more. As always, do your due diligence before investing in any investment vehicle.  

Dividend distributing ETFs are ideal for those investors looking for liquidity, those looking for a steady stream of income, and those who don’t have a high taxation on supplementary income. Certain markets have tax loops that allow investors to avoid these extra costs.   

It also depends on your income. For example, if you’re not earning or are retired, dividend ETFs work as a great secondary source of income. These ETFs will typically pay out a quarterly payment for all dividends received. As a result, dividend distributing ETFs are more suited to those in their later years.   

Dividend ETFs are also ideal on a cost basis. With accumulation ETFs, if you want cash you need to sell a portion of your ETF, and the transaction fees can add up. This issue doesn’t apply to dividend ETFs.  

However, if you have a longer time horizon, then accumulating ETFs will make more sense for you and your investment goals. At arty, we choose to work with accumulating ETFs for their simplicity and the ease of use for everyone involved, but if you are interested in investing in dividend distributing ETFs, in need of a distribution plan, or are looking for recurring liquidity, we are happy to discuss this with you and find personalized solutions on a case-by-case basis. 

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