ETFs, or Exchange-Traded Funds, that invest in stocks pay dividends when companies of the stocks tracked by the funds make their dividend distributions. Thus, ETF investors receive dividends collectively from a fund's portfolio of companies. In comparison, investors investing in individual stocks receive their dividends separately from each company. To qualify for receiving dividend payments, individual-stock investors must be on a company's shareholder list by its dividend-record date. Investing in ETFs eliminates the need to track different dividend-record dates from different companies. Not all ETFs are designed to pay dividends. ETFs that do intend to pay dividends have different ways of achieving dividend growth.
Investing for regular equity income rather than varied equity appreciation can be an appropriate investment strategy for certain investors. While many ETFs primarily aim to grow their investment base over time, some ETFs are set out to invest in dividend paying stocks mostly for steady, fixed income. ETF investors interested in receiving dividends should look for dividend-paying ETFs. Growth-oriented ETFs likely invest in stocks that have growth potential, but may not pay dividends.
In order to select stocks that make consistent dividend payments, dividend-paying ETFs usually focus on investing in certain companies and particular industries that are known for delivering high dividend payouts, such as the financial sector and utilities companies. Dividend-paying ETFs may not be a good fit for ETF investors looking for investment diversification as these funds tend to have more concentrated portfolios.
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Dvidend Yield vs. Dividend Growth
In selecting dividend-paying stocks, ETFs often factor in both dividend yield and dividend growth. Dividend yield is the percentage of dividend paid on a stock at a given time relative to the then stock's trading price. Dividend growth is the average growth rate of the dividend payouts on a stock over time. Occasional high dividend yields may not be indications of future dividend growth. In fact, some companies may lose their earnings power in down times simply because they are not ready with enough resources due to ineffective earlier allocation of fund uses including overpaying dividends.
To provide steady dividend payments to ETF investors, ETFs need to rebalance their portfolio holdings over time, dropping companies that cannot keep up with their dividend payments and adding companies that have seen stable dividend increases. Additionally, an ETF would assign higher weights to stocks that have improved on their dividend payments and reduce weights on stocks that have cut their dividends.
For risk-aversion investors, dividend-paying ETFs provide an alternative investment to bonds and other fixed-income securities whose rates of returns are normally lower. But in the meanwhile, investors forgo potential capital appreciation as dividend-paying ETFs tend not to invest in growth but risky companies. Although not intended to achieve a broad investment diversification among sectors and industries, investing in dividend-paying ETFs can be used as hedge against potential market down turns.
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