What is a Dividend ETF and Should You Invest In It?

An investor’s primary goal from an investment is to generate returns through capital appreciation. However, some equity investments can also help one earn an additional income in the form of dividends. Dividend-paying stocks are popular amongst experienced and new investors alike, but picking the right stocks can be a challenge. Here’s where a dividend ETF comes into play. Read on as we learn more about what dividend ETFs are and who should invest in them.

What is a Dividend ETF and How Does It Work?

An exchange-traded fund (ETF) is a financial instrument that is traded on the stock exchanges, similar to stocks. These funds gather money from several investors and invest it into a basket of securities such as stocks, indices, commodities, and bonds. The primary purpose of these funds is to replicate the returns of the underlying asset.

A dividend ETF is typically a passively managed ETF that tracks a dividend-focused index such as the Nifty Dividend Opportunities 50 Index. Here, the fund managers do not select individual stocks; instead, the ETF follows the rules of the index.

Although a dividend ETF is passively managed and tracks a particular index, fund managers play a role in filtering and selecting companies based on dividend yield, higher liquidity, and strong past performance of dividend payouts.

For example, a dividend ETF may track an index of global dividend-paying stocks. The ETF comprises stocks that meet the index criteria, regularly pay dividends, and also meet additional select criteria. Some ETFs may also invest in blue-chip companies that have a track record of stable performance and strong fundamentals. When an investor invests in a dividend ETF, they can gain exposure to several dividend-paying companies through a single ETF.

Benefits of Dividend ETFs

There are several key benefits of investing in a dividend ETF.

Broader Exposure

By investing in a dividend ETF, an investor can gain broader market exposure, as these ETFs include companies from various sectors and industries. Some ETFs offer international exposure, resulting in greater diversification. While some ETFs distribute dividends periodically, there are ETFs that automatically reinvest the dividends.

Dividend Income

One of the primary benefits of a dividend ETF is the dividend payouts that an investor can receive. When companies earn a profit, they may distribute a portion of it to investors in the form of a dividend. This can be an ideal way to generate a passive or additional income source.

Liquidity

Similar to other ETFs, a dividend ETF can be traded on the stock exchange. An investor can buy and sell units of an ETF similar to trading shares. The liquidity of ETFs allows investors greater flexibility in managing their investments.

Enhanced Stability

Dividend-paying stocks are usually well-established companies that have strong financials. Investing in them provides more stability to investors. Moreover, a dividend ETF invests in companies in different sectors and industries, which aids in spreading the risk and creating a more robust portfolio.

Risks of Dividend ETFs

Here are some risks that investors should consider before investing in dividend ETFs

Market Risk

Dividend ETFs are equity investments that expose investors to market risks. Economic downturns, geopolitical tensions, or changes in policies can impact the performance of the market and, in turn, impact the performance of the ETF.

Impact on Dividend Yield

The dividend yield of a dividend ETF is based on the average of all the underlying stocks. Fluctuations in the dividend payout of one company impact the overall payout of the fund. The overall yields can be significantly impacted by cuts from larger index constituents.

Reduced Control

Dividend ETFs are passively managed by fund managers who make confident decisions. This reduces the amount of control the investors have over the stocks included in the fund.

Who Should Invest in Dividend ETFs?

• Dividend ETFs are an ideal investment option for investors looking to generate a passive income through the form of dividends.
• Dividend ETFs are also suitable for investors seeking broader market exposure and aiming to build a well-rounded portfolio.
• Newer investors who want to add dividend-paying stocks to their portfolio can gain exposure to several stocks through a dividend ETF.

Dividend ETFs vs. Growth ETFs

Dividend ETFs and Growth ETFs both have their benefits but differ significantly from each other.

Dividend ETFs and Growth ETFs both have their benefits but differ from each other significantly.

How are Dividend Funds Taxed in India?

Dividend ETFs are treated as equity investments. Depending on the holding period of the ETF, the gains on the investment may attract short-term or long-term capital gains tax. Previously, dividends received from an ETF were subject to dividend distribution tax (DDT). However, from FY20-21, the dividend received is treated as part of the individual’s income and is subject to taxation as per the applicable tax slab. Additionally, dividends above ₹5,000 per year attract 10% TDS.

How to Choose the Right Dividend ETF

• Check the Dividend ETF’s past dividend yield to get a better idea of the income generation potential.
• ETFs with high dividend growth indicate stability, growth, and sound financials of the companies in the portfolio.
• Check how frequently the ETF distributes dividends. Ensure that the dividend distribution frequency matches your investment goals.
• Study the ETF's portfolio to identify if the fund is over-concentrated in a particular sector.

Conclusion

Dividends can be a valuable source of passive income that can help you meet your day-to-day expenses, or the funds can be reinvested to benefit from the power of compounding. Through a dividend ETF, investors can get broader exposure to numerous dividend-paying stocks, which can provide stability and also broader market exposure.