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Have you been wondering about exchange traded funds (ETFs) and whether they dish out dividends? We get it. Dividends can be like that happy surprise on a random day. It’s the little extra something that makes long term investing more rewarding.

In this blog article, we’ll unpack the nuanced answer to the question: “Do ETFs pay dividends?” First, we'll break down the concepts of ETFs and dividends. Then, we’ll explore the factors that determine whether an ETF pays dividends (or not). This article will also share some insights on whether there’s more to high-yield ETFs than meets the eye.

Understanding exchange-traded funds (ETF) and dividends

Before we explore the connection between the two, let’s take a moment to understand the basics.

What are exchange traded funds (ETFs)?

Think of an exchange traded fund (ETF) as a basket of assets such as shares, bonds or commodities. It’s like a well-curated playlist of your favorite songs. Additionally, ETFs are like a mutual fund and individual share rolled into one. You get to spread your investment around while still being able to buy and sell the ETF whenever you want.

However, there are key differences between mutual funds and ETFs. Unlike a mutual fund, ETFs passively mirror the performance of a specific index or sector. The most popular Australian shares ETFs, for example, follow the ASX 200 in Australia. There are even focused thematic ETFs; these track specific themes or trends, such as sustainability or the latest innovations. (And in case you’re curious about it, here’s a related read: “Thematic ETFs: overhyped or smart investing?” )

Other potential benefits of investing in ETFs include simplicity and affordability to investors of all stripes. Compared to a mutual fund, a passively managed ETF typically has lower costs for holding your investment.

What are dividends?

Now, let's talk dividends. When a company makes a profit, it has the option to distribute some of those earnings to its shareholders. These payments are known as dividends. Think of them as a bonus cheque for supporting their company.

For an income investor, that extra cash can really make a difference. They could use it to reinvest, or maybe to cover some daily expenses. If you are an Australian resident and are looking for a walk-through on dividends, check out our comprehensive guide to dividends.

Do ETFs pay dividends?

No drumroll needed—exchange traded funds (ETFs) can pay dividends! However, not all ETFs are on the dividend bandwagon. Whether an ETF gives those payouts depends on what it's holding inside. Some ETFs focus on capital gains; others put dividend income front and centre.

A. Dividend ETFs

Dividend ETFs are designed to invest in company shares that offer regular dividend payments. The Select Dividend iShares ETF (US:DVY) is one example of this category. This ETF typically focuses on US companies that have a good history of paying high dividends.

There can be many reasons why investors focus on dividends instead of share prices. For starters, getting regular income from dividends can motivate one to stay in the investing game for a long time.

To know whether your ETFs pay distributions, you can simply check the prospectus or the fund's website. Dividend ETFs typically mention the distribution policy and their history of dividend yields.

B. Growth ETFs

On the other hand, some ETFs are not specifically designed to focus on dividends. Instead, they may prioritise capital gains or track indices where dividend yields are relatively lower.

The fund might decide to put its money into companies that are expected to take off in the future. Often these focused ETFs invest in sectors like emerging markets.

Although these ETFs may not pay dividends, investors can still benefit from capital gains when the ETF's share price increases. This category of ETFs may also offer to reinvest any income they receive back into the fund. The money goes towards compound interest, increasing the fund's value over a period.

Factors that determine whether an ETF pays dividends

We talked about how the assets in an exchange traded fund (ETF) are put together and how it all relates to dividends. However, there are a few other things that matter when figuring out the answer to the question “do ETFs pay dividends?”.

Composition of the ETF

Chosing the right ETF for you can be like picking a salad with all your favourite toppings. The underlying assets of an ETF can play a significant role in determining dividend payouts.

Some ASX ETFs, for example, target Australian companies known for consistent dividend distribution. On the other hand, some Gold ETFs provide dividends, but their yields are less likely to attract even a conservative income investor.

Investing strategy

Imagine you have a friend who's a master at finding money-making opportunities. They have a knack for identifying companies that pay out juicy dividends. Well, high-yield ETFs (also known as yield maximiser funds) are like having that friend in your investing team.

A yield maximiser fund seeks out company shares with historically high dividend yields and pools them together. Like other ETFs with different focus, this fund taps into various sectors and regions for a diversified income portfolio. Of course, just as your money-making friend has fumbled a few times, no yield maximiser fund is impervious to risk. With ETFs - as with any investment - past performance doesn't indicate future returns.

Dividend policies

Each ETF has its own "dividend policy". This spells out what they'll do with the money from dividends the underlying assets earn. Some ETFs pay dividends and deposit the cash straight into the shareholder’s bank account. The other popular option is called a dividend reinvestment plan (DRP).

With a DRP, you have the option to automatically reinvest the dividends you receive back into the ETF. Opting into a DRP allows you to buy more shares without spending an extra cent. Reinvestment plans have been a popular option for investors who want to benefit from the power of compounding over many years.

Dividend tax and franking credits in Australia

Ah, franking credits! They add a twist to the dividend story, especially in the land down under. In Australia, companies often attach franking credits to their dividends. And it typically means tax benefits for investors.

But wait - what are franking credits? They represent the tax already paid by the company on the profits distributed as dividends. When you receive a franked dividend, you may be eligible for a tax offset or refund. Still, it depends on your circumstances.

Just a heads up: rules for filing your tax returns can be different depending on where you're at. It's always a good idea to check with a tax expert and get professional advice on your situation. The Australian Taxation Office (ATO) website also provides helpful guides on dividend tax.

Market conditions

You know how sometimes the market just isn't doing so great? It’s a natural part of the market cycle, but that can make it harder for an ETF to pay dividends. When companies aren't doing so well, they might have to cut back on those distributions. To make the story short, it means less money for your dividend ETFs.

Why would investors buy ETFs that don’t pay dividends?

Let's say you come across an ETF that doesn't pay any dividends. At first glance, it might seem counterintuitive to consider such an investment. However, there are several reasons why investors might find dividend-free ETFs enticing.

Let's uncover a few:

Growth focus

Some investors prioritise long term capital appreciation over immediate regular income. By picking growth ETFs, they’re hoping the prices will go up instead of waiting for dividends to arrive.

Of course, every investment decision depends on your risk appetite and personal situation. Growth ETFs are sometimes a preferred option for those who can wait for the potentially bigger cash-out after decades of holding the investment (assuming the market fares well).

Tax efficiency

Dividends received from ETFs are subject to taxation, impacting investors' tax returns. If it's a concern, ETFs that have a dividend reinvestment plan (DRP) have often been touted as a tax-efficient alternative.

Diversification

You can invest in broad-market ETFs or specialised ETFs to ensure you're not putting all your eggs in one (dividend-paying) basket. The diversification means you won't be dependent on potential dividend earnings. You’d also be allowing yourself to taste different opportunities for investment growth.

Simplicity

By choosing ETFs that don't pay dividends, investors can enjoy the simplicity of a single investment vehicle that grows over time. They don’t have to worry about tracking and managing multiple dividend payments.

Are dividends an indicator of an ETF’s value?

It’s the age-old question. Let's clear the air once and for all: while dividends can be a sweet bonus for investors, they shouldn't be the sole indicator of value. Many income investors try to chase high dividend yields, but they miss the plot—it’s often unsustainable.

Rather, the worth of any ETF depends on how well its assets are doing and what's happening in the industry or the overall market. The dividends are just one piece of the puzzle.

Let's bring this topic to life with a quick hypothetical scenario

Say that you find the (obviously fictional) XYZ High Dividend ETF. This shares ETF has gained popularity because it offers an enticing dividend yield of over 8%. However, solely relying on the dividend yield may not paint the full picture of the shares ETF's value.

On the surface, it seems like a no-brainer for an income investor. However, a deeper analysis reveals that the shares ETF's price has been declining for a while now. So, while you'll still get your dividends, the actual value of your investment might be eroding.

Here's the thing: regular cash flow is desirable, but an ETF’s value is more than just the immediate rewards. The key is to consider dividends alongside other factors. Here's what you want to look for: expense ratio, diversification, and historical performance.

To wrap it up…

There you have it! We've reached the end of our deep dive into the realm of ETFs and dividends. Here’s the TL;DR: ETFs can pay dividends, depending on several factors. Understanding the factors at play can help you find the right ETF that meets your dividend goals.

Do you have any questions or experiences with ETFs paying dividends? Share your thoughts with us and let's keep the conversation going. Or maybe you’re looking to buy your first ETF? For more information, listen to the Get Rich Slow Club episode on finding the right broker for investing in ETFs.

Always remember: the road to wealth is paved with a lot of discipline and investing knowledge.

Happy investing!