Dividend ETFs: selection, limits and costs

Dividend ETFs track indices that select companies by the level or the consistency of their dividends. Some investors value regular distributions, for example to cover ongoing expenses. It is important to understand what a distribution is – and what it is not.

A distribution is not extra return

When a company or a fund pays a dividend, its value falls on the ex-date by roughly the amount paid out. Total return consists of price change plus distributions. A high dividend yield therefore does not automatically mean a high total return.

Two typical selection methods

1. Consistency: the index includes companies that have maintained or increased their dividend for many years (often with “Aristocrats” in the name). The minimum period and other rules differ from index to index.
2. High dividend yield: the index selects companies with the highest current dividend yield, often with filters that check whether the payout is covered by earnings. A high yield can also be the result of a sharp price fall.

What changes compared with a broad market index

• Sectors and countries: dividend indices often give more weight to financials, utilities, energy and consumer staples and less to technology than broad market indices.
• Fewer holdings: many dividend indices contain far fewer companies than a broad index, which increases concentration risk.
• Style effect: dividend strategies often share characteristics of value strategies. Their performance can deviate substantially from the broad market over long periods – in either direction.

Risks

• Dividends can be cut or suspended, especially in economic crises.
• Companies can also fund dividends from reserves or debt; a dividend alone is not proof of financial strength.
• For funds in a foreign currency, distributions also fluctuate with the exchange rate.

Taxes and costs

• In many countries, distributions are taxed in the year they are received. With accumulating funds, taxation is partly deferred; some countries tax them annually on a notional basis. The details depend on your country of residence.
• Foreign withholding taxes can reduce the net distribution.
• Dividend ETFs often have higher ongoing charges (TER) than ETFs on broad market indices.

Distributions or selling units?

There are two ways to generate ongoing income: using distributions or regularly selling units, including units of accumulating funds. With the same total return, both lead to similar results before taxes and costs. Differences arise mainly from taxes, costs and the different composition of the indices. If distributions are not sufficient, units have to be sold or spending adjusted anyway.