We know that ETFs are a good way to diversify your portfolio. We also know dividend stocks are some of the best ways to build wealth over time. Can you combine these two? Do ETFs pay dividends? That’s the question on the mind of many investors when they’re looking to build their portfolio.
But maybe we should slow down. What are ETFs? For that matter, what are dividends? The quick answers are this: An ETF, or exchange traded fund, is kind of like a greatest hits album from The Rolling Stones. You may not have enough money or time or space to buy every single Rolling Stones album. (That’s somewhere around 80 albums if you count studio, live, and compilation albums.) But the 46-track album, Honk, will give you hits like “Start Me Up” and “Tumbling Dice,” plus a general overview of their career. Similarly, an ETF gives you a little bit of a lot of different stocks, usually following a particular index like the S&P500.
Dividends are shares of profits that companies pay you for owning their stocks. That would like if the Rolling Stones paid you a little every time they sold records. Pretty cool, yes?
So do ETFs pay dividends? They do. ETFs may pay the dividend as cash or they’ll provide additional shares of the ETF to you.
Overall, there are two types of dividends that an ETF can pay: Qualified dividends and non-qualified dividends. Qualified dividends experience a long-term capital gains tax rate, while non-qualified dividends are taxed based upon the investor’s income tax rate.
Do ETFs pay dividends? Understanding the value of dividends
Dividends are a sign of investment quality. If an ETF or a stock pays a dividend, then you know the company is in good financial standing. Dividends cannot be faked, and there needs to be a genuine profit for the company to pay a dividend. If an ETF or stock you own pays a dividend currently, you can feel confident that you own a successful asset. Dividends show the historical value of a company, but they also send a message about potential future performance.
It is worth noting that if a dividend yield is high, but the ETF or stock is priced relatively low, that can signal potential problems. There may be a lack of interest in this company because of earnings issues or slow growth. It would be valuable to look deeper into the company to ensure that they aren’t in a financial position where it will need to cut its dividend.
How to find the best ETFs for your diversified portfolio
The best ETFs are passively managed, have low management rates, come with diversification, and have a low holdings turnover. ETFs with a history of paying a dividend can show that the company is well managed and positioned to continue profitability. Although there is value in knowing the historical production, it is even more impactful to look at the current yield, the expense ratio, and the investment’s objective.
In addition to historical data, consider the dividend payout ratio, which is calculated by taking the annual dividend per share and dividing that number by the earnings per share. If a dividend yield is high and the payout ratio is low, the company should be in good standing to sustain its dividend payment.
There are even ETFs that specifically track holdings that pay dividends, so you can always include dividend ETFs in your search.
Do ETFs pay dividends? How to avoid low-quality ETFs
Some of the worst ETFs to invest in are “new” ETFs that are actively managed and have a variety of fees associated with this active management. Furthermore, ETFs that are seen as “illiquid” can become an issue to trade. It is also good to avoid ETFs that are focused in areas of political or environmental unrest. Ensure that the ETFs you invest in are diversified enough to avoid problems.
Dividend-paying ETFs, like dividend-paying stocks, can be a good addition to most investment portfolios.
How do you determine the ETFs that are right for your diversified portfolio?