Want to try your hand at income investing? A dividend-paying exchange-traded fund (ETF) is a great starting point. The best income ETFs are diversified, low maintenance assets that throw off cash and appreciate over time.
Read on below to learn more about ETFs and how they work. We’ll also cover four of the best dividend ETFs for 2023 and the essential factors to consider when selecting income ETFs.
What Are ETFs?
An ETF is an investment fund that trades on an exchange, like a stock. Exchange trading occurs throughout the business day. ETF shares are repriced at each transaction, based on supply and demand. This intraday repricing distinguishes ETFs from mutual funds, which are repriced once each business day.
Usually, an ETF’s trading price equals its net asset value or NAV—but it doesn’t have to. Very optimistic investors can bid an ETF’s price up to be higher than the per-share value of its assets. Likewise, pessimistic investors can push the price down below NAV. These situations, while possible, tend to be fleeting. Generally, any premium or discount on an ETF will disappear quickly.
Passive Vs. Active ETFs
ETFs can be passively managed or actively managed. Passive ETFs, sometimes called index ETFs, mimic the performance of a benchmark index.
An index is a themed grouping of securities. You are probably familiar with the S&P 500 and the Dow Jones Industrial Average indices, for example. Indices can focus on stocks in a certain sector, companies that share specific financial qualifications or companies of the same size, etc. There are many indices, not only for stocks, but for other assets classes as well.
Active ETFs have fund managers who decide what assets should and should not be in the fund’s portfolio. These decisions are guided by the fund’s investment approach. That approach may reference an index, but the fund manager has leeway to deviate to improve performance.
Passive index ETFs have the advantage of being cheaper to operate than active ETFs. If the components of the index change, the fund automatically updates its holdings. With that model, there’s far less human decision-making and intervention required. As a result, index ETFs have lower expense ratios than active ETFs. This often translates to higher returns because the expenses reduce the money invested in the portfolio.
How Do ETFs Work?
ETFs use money raised from their shareholders to buy and manage a portfolio of assets. Each shareholder in turn owns a piece of that portfolio. When shareholders decide to sell, they transfer their ownership stake in the portfolio to someone else and receive cash in return.
Stocks have a similar ownership model. Most investors can’t afford to buy a whole company outright, so they invest in a small piece—one or more stock shares. ETFs work the same way, using a collection of assets rather than a single company.
The ETF then rises and falls in value based on the aggregate movements of all the assets in the portfolio. Often, the aggregate volatility of an ETF will be lower than that of a single stock—because growth in some positions will offset declines in others.
With inflation running at 4.0%, dividend stocks offer one of the best ways to beat inflation and generate a dependable income stream. Download Five Dividend Stocks To Beat Inflation, a special report from Forbes’ dividend expert, John Dobosz.
The Best ETFs For Income Investors
Now, to the heart of the matter: Can you use ETFs as income-generating assets? Absolutely. ETFs can be good income producers because they’re collecting diversified dividend streams. That diversification moderates any income changes you might see from individual companies changing their dividend policies.
If you’re new to income ETFs, it’s best to start with low-fee funds that invest in large-cap, domestic, dividend-paying stocks. Four of the best ETFs to buy in this category are:
- Vanguard Dividend Appreciation ETF (VIG)
- iShares Core High Dividend ETF (HDV)
- SPDR S&P Dividend ETF (SDY)
- Schwab U.S. Dividend Equity ETF (SCHD)
Below is an overview of each one.
Vanguard Dividend Appreciation ETF (VIG)
IG tracks the performance of the S&P U.S. Dividend Growers Index, which focuses on large-cap stocks that increase their dividends annually. There are 314 stocks in the portfolio, spread unevenly across ten economic sectors. Technology, financials and healthcare have relatively more exposure than other sectors. Real estate is the only sector not represented.
VIG’s expense ratio is 0.06%. The fund has returned an average of 8.9% annually since its 2006 inception, which is 11 basis points lower than its underlying index. (The difference in performance between the fund and the benchmark index is known as tracking error. Fund expenses are usually the largest component of an ETF’s tracking error.)
VIG’s current dividend yield is 1.9%.
iShares Core High Dividend ETF (HDV)
iShares invests in high-quality domestic companies that pay competitive dividends. The fund tracks an index that includes 75 stocks that meet minimum financial health metrics. Top holdings include ExxonMobil (XOM), Johnson & Johnson (JNJ), Verizon Communications (VZ) and Abbvie (ABBV).
HDV’s expense ratio is 0.08% and its yield is 4.26%. Since 2011, the fund has returned an average annual total return of 995%, while its benchmark has returned 10.0%.
SPDR S&P Dividend ETF (SDY)
SDY holds 121 S&P 500 stocks that have increased their dividends for at least 20 consecutive years. The ETF provides exposure to all 11 economic sectors, with industrials, consumer staples, utilities and financials comprising more than 65% of the portfolio.
SDY has the highest expense ratio among our best income ETFs at 0.35%. The fund yields 2.8% and has returned an average 8.5% annually since 2005. In this metric, the fund lags its benchmark index by 32 basis points.
Schwab U.S. Dividend Equity ETF (SCHD)
SCHD tracks the Dow Jones U.S. Dividend 100 Index, which is designed to include high-quality stocks with sustainable dividends. There are 104 large-cap stocks in the fund, operating in all economic sectors except real estate. The bulk of the stocks are in industrials, healthcare, financials, consumer staples and technology.
SCHD has a moderate expense ratio of 0.06% and it yields 3.6%. The fund’s ten-year average annual return is 11.1%, vs. 11.2% for its benchmark index.
With inflation running at 4.0%, dividend stocks offer one of the best ways to beat inflation and generate a dependable income stream. Download Five Dividend Stocks To Beat Inflation, a special report from Forbes’ dividend expert, John Dobosz.
Factors To Consider When Choosing An ETF
While you might like one or two of the best dividend ETFs listed above, you can and should develop your own method of choosing income funds. Important factors to consider in your income fund investing approach are dividend yield, expense ratio, risk and investment objective.
Dividend Yield
Dividend yield is the ETF’s total annual dividend payment divided by the fund’s share price. If a fund pays $5 annually and sells for $200 per share, the dividend yield is 2.5%.
Use dividend yield to evaluate and compare an ETF’s income potential to its peers. Risk, discussed below, should also be a factor in yield comparisons. This is because higher yield ETFs often come with higher risk.
Expense Ratio
The expense ratio is a measure of the fees you pay as a fund shareholder. Lower is better. A lower expense ratio means more of your money stays invested and generates returns.
Index ETFs have low expense ratios, usually less than 0.08%. A 0.08% expense ratio means you pay $8 annually for every $10,000 you have invested in that fund.
Risk
Riskier ETFs can show more volatility in both share price and dividend income. Accepting that risk may come with the potential for higher dividend yields, however.
Before investing in any ETF, consider how much volatility you want to manage. This is an important factor, because the best-performing ETFs in one market climate can become the worst-performing ETFs when the markets shift.
If you are risk-averse, lean into ETFs that hold large, domestic companies that have been paying dividends for many years. Steer clear of smaller companies and foreign stocks, even if they promise bigger yields.
Investment Objective
An ETF’s investment objective explains how assets are selected for the fund. As an example, the investment objective for iShares Core High Dividend ETF (HDV) is, “to track the investment results of an index composed of relatively high dividend paying U.S. equities.”
When the investment objective references an index, look up the index to learn more about the assets in the ETF. Continuing with the HDV example, the fund literature identifies the underlying index as the Morningstar Dividend Yield Focus Index.
A quick review of Morningstar’s documentation reveals that Dividend Yield Focus Index constituents must meet several criteria, including:
- The payment of a qualified dividend in the last 12 months
- A three-month average trading volume of $1 million or more
- A Morningstar Economic Moat Rating or a Quantitative Moat Rating plus a Distance to Default Score.
Evaluate those qualifications against your own investment goals to determine if the fund is a good fit.
Best ETF FAQs
What Is the difference between an ETF and a mutual fund?
ETFs trade on an exchange, like a stock. The buy and sell transactions happen throughout the trading day and the price of the ETF fluctuates accordingly. Mutual funds, on the other hand, settle all transactions once each business day. The price of a mutual fund is equal to its net asset value (NAV). NAV is the value of the fund’s portfolio, divided by the number of outstanding shares. ETFs also have NAV, but they can trade for more or less than NAV based on investor demand.
What Is the average dividend yield for an ETF?
Average ETF dividend yields vary by sector and the fund’s investment approach. Many ETFs deliver yields in the range of 2% to 3%. ETFs that specialize in higher-yielding assets, like REITs or financial stocks, may yield 3% to 5% or more.
What Is the expense ratio for an ETF?
An ETF’s expense ratio represents the amount shareholders are charged annually for fund expenses. Index ETFs are passively managed and have very low expense ratios, usually below 0.08%. Actively managed ETFs have higher expense ratios.
What is the risk of investing in an ETF?
The primary risk of investing in an ETF is value loss due to market fluctuations. Say you are invested in an ETF that tracks the S&P 500 large-cap index. When that index dips by 20%, the value of your ETF will also fall. You’ll see a slightly higher value loss in the ETF vs. the index because ETFs have fees which reduce returns.
What is the investment objective of an ETF?
The investment objective defines the types of assets in the ETF. Many ETFs seek to replicate the performance of an index, such as the S&P 500 High Dividend Index or the Dow Jones U.S. Dividend 100 Index.
With inflation running at 4.0%, dividend stocks offer one of the best ways to beat inflation and generate a dependable income stream. Download Five Dividend Stocks To Beat Inflation, a special report from Forbes’ dividend expert, John Dobosz.
