When you reach a point in your investment journey where you are looking for more passive income, dividend funds can seem very attractive. An ETF or mutual fund that regularly deposits cash into your brokerage account can feel like a simple way to generate the passive income you’re seeking. Dividend ETFs can make sense for many investors, since they offer a convenient way to own a diversified collection of dividend-paying companies, but they are not a magic bullet.

The important distinction that you need to be aware of is the one between receiving income and earning a return. A dividend is PART of the return, not an additional return on top of price appreciation. So, the best dividend ETF depends on your overall investment and financial goals, but a high-dividend yield alone is rarely a compelling reason to choose one fund over another.

What Is a Dividend?

At its simplest, a dividend is a distribution of a company’s earnings or other available capital to shareholders. Dividend ETFs pass along any dividends received from the stocks they own to their shareholders. Here’s a simple example:

  • You own $10,000 of a stock or ETF.
  • It pays a 3% dividend, or $300.
  • You receive $300 in your account, but generally the investment’s value also falls by around $300.
  • You have not created an extra 3% return. You have received part of your investment’s return in cash.

This is captured in the dividend irrelevance theory—a 3% dividend is not magic money that you get for free. It’s simply a part of the return. You should also understand that a stock’s dividend yield is not the same as its total return. A fund (or stock) can have a high dividend yield and still have a declining share price.

Having said that, dividends can still be useful, since they can provide you with cash flow without having to sell your shares. They can also be psychologically appealing, especially for retirees. Generally, companies that pay a dividend do so because they have profitable, established businesses with extra cash on hand. That’s often better than a company that has no cash or profit, though many successful companies choose not to pay a dividend and instead invest their profits back in their business.

More information here:

What Makes a Good Dividend ETF?

Morningstar keeps a list of good dividend ETFs, but the list can often change over time. If you’re looking for good dividend ETFs, it’s better to instead focus on the characteristics that make a dividend ETF worth considering rather than just looking at a static ranking at one point in time. Here are some things to look for as you select a dividend ETF that works for you:

  • Choosing one with a sensible strategy (overall high dividend yield, balancing yield with growth, etc.) that fits your overall investment goals
  • A fund with a consistent track record of sustainable dividends
  • One with low expenses
  • A fund that is tax-efficient, especially if you’re holding it in a taxable brokerage account instead of an IRA
  • Diversification and overall portfolio fit

Should High Earners Focus on Dividends?

For most investors, total return is what matters. A portfolio’s overall return comes from both dividends and changes in share price. Focusing on one component of a fund’s return over another does not automatically improve the result.

Another thing to consider for doctors or other high-earning professionals is that dividends in a taxable account generally create taxable income in the year they are distributed. While qualified dividends may receive favorable tax treatment, they are not tax-free. Investing in a dividend ETF that has a higher dividend yield can therefore create more annual tax drag, particularly for someone in a high tax bracket who does not need the cash.

Still, dividend ETFs may still make sense in a situation where they provide a desired value or component of an overall portfolio, or if you want cash flow in retirement or prefer the behavioral comfort of receiving dividends. Holding a dividend ETF in a tax-advantaged account like a Roth IRA can also provide an advantage, since you don’t have to worry about the taxability of dividends.

Dividend ETFs vs. a Total Return Approach

You can create income from your portfolio in one of two ways—either sell a portion of your portfolio when you need cash, or receive dividends and interest from your investments. Both of these strategies can make sense, and it’s usually a good idea to incorporate both of them into your overall strategy.

Focusing on your total return gives you more flexibility, since you won’t be limited to the companies or sectors that happen to pay the highest dividends. Dividend-focused funds can introduce an unintended bias toward value stocks, financials, utilities, energy, consumer staples, or other sectors that happen to pay out dividends.

More information here:

The Bottom Line

A dividend ETF can be a useful investment, but the highest-yielding ETF is not automatically the best one. Instead, evaluate things like a fund’s strategy, diversification, expenses, dividend sustainability, tax implications, and role in the overall portfolio before deciding to invest your money. For high-income investors still accumulating wealth, a broad, low-cost, tax-efficient total-return portfolio will often be a better default than chasing dividend yield.

Dividend ETFs can have a place in your portfolio, but make sure that you’re choosing one because it fits your investment plan, not simply because it happens to pay a large dividend.

The White Coat Investor is filled with posts like this, whether it’s increasing your financial literacy, showing you the best strategies on your path to financial success, or discussing the topic of mental wellness. To discover just how much The White Coat Investor can help you in your financial journey, start here to read some of our most popular posts and to see everything else WCI has to offer. And make sure to sign up for our newsletters to keep up with our newest content.

Did you find this article helpful? Share it!