How Do Index Funds Pay Dividends

Investors has always attracted to stocks with steady and consistent dividends. Some of the Best Dividend ETFs provide consistent dividends for investors year in and year out. The strategy of investing in index funds that focus on dividend strategy can very rewarding. Dividend index funds can be split between investing in companies that has a record in paying dividend and growing the dividend payout overtime or jumping straight into high yielding stocks.

Stock Market Index Fund

The level of dividend index funds pay is dependent on the underlying companies in the funds. Typical medium term dividend yield of S&P 500, which accounts for 500 of the largest listed US companies is around 1.80%. Index funds pays dividend when the underlying company pays out a dividend. Hence the profile of dividend varies dependending on the kind of stocks the index fund tracks.

For a broad market fund like the S&P 500 (or index funds which tracks foreign markets such as China or Russia) then the fund pays dividend after the components of the index has declared and paid out the quarterly, semi annual dividends.

We have highlighted 3 different dividend focused index funds with each have a different approach in capturing dividend for investors and ranked them relatively from Lowest to Highest.

Ticker ETF Yield Ranking
DVY iShares Dow Jones Select Dividend Medium
DWX SPDR S&P International Dividend Highest
DES WisdomTree SmallCap Dividend Lowest

Not All Dividend Dividend Paying Index Funds Are Created The Same

Not all dividends from index funds are the same. DVY tracks companies that has a history of paying and growing dividends. DWX with almost double the yield of DVY because it invests in highest yielding companies. A minor variation in dividend investing strategy makes a world of difference.

While the former could be seen safer as the current dividends grew over time. It therefore can be considered to be more sustainable. There could be a number of reasons that a stock has a high yield.

1. Stock price has fallen so low that the high yield can be misleading

2. The market can doubt the sustainability of current dividend payout

3. Investors expect the dividend to be cut.

Based on the above factors, investors should be cautious in choosing the right dividend index fund for their portfolio.


The Mature Company Dividend Index Fund

iShares Dow Jones Select Dividend ETF (DVY) similar to Dow Jones ETF tracks the Dow Jones U.S Select Dividend Index. It is one of the largest dividend paying index funds as measured by asset under management. DVY invests in large capitalized and mature companies with average market cap of companies around $36 billion. Stocks in the DVY is liquid as it can be with low average spread and high trade volumes which means it has low bid-offer spread on ETF level.

This dividend heavy index fund is able to pay larger than average dividends because it invests in mature companies. Major holding analysis shows it include blue chip stocks that every investors know such as the largest holding, Lockheed Martin Corporation, oil majors like Chevron Corporation and consumer companies like McDonald’s.

As DVY invests primary focus is on dividend companies, the sector breakdown of the fund shows that it is heavily on defensive sectors with cash flow backing the dividends like Utilities (36%), Industrials (13%), Consumer non-cyclicals (12%) and Financials (8%). It is also broadly diversified with over 100 holdings in the fund.

DVY is a good dividend index fund for conservative investors. There is no such thing as a sure thing in investing. However focus on large companies limit some degree of risks.


Interesting Small Cap Index Fund That Pay Dividend

WisdomTree SmallCap Dividend ETF (DES) is a small capitalization dividend weighted index fund. Normally investors would not consider small capitalized stocks to capture dividend especially with risks of associated with small capitalized stocks which can be compensated with higher returns.

Related: Read our Small Cap ETF analysis to find out which ETF you should use if you want small cap exposure to your portfolio.

DES offset the associated risk by over diversifying the stocks included in the portfolio. The ETF includes 1300 different stocks with average market capitalization of $1.6 billion. This means the fund performance is not dependent on a particular group of stocks, only broader market, risk sentiment and trends.

Investing in a small capitalization fund also limit liquidity risk of investing in small capitalization stocks. The average spread is only 0.08% with heavy daily volumes. It is easy for investors to enter and exit the stock compared to investing in small caps directly.

From looking at sector breakdown of DES, there are couple risks investors should note.

– DES is heavily focused on the Financial sector (27%).

– Other sectors shows a cyclical emphasis with Industrials (16%) and Consumer Cyclicals (11%) and Basic Materials (8%) all in the top 5 largest sector exposures

– Smallest exposure to Telecom (2.66%) and Energy (3%)

In the years following the financial crises 5 year return of DES resulted in annualised return of 22% with almost 3% yield. Volatility has been minimal however investor should note volatility can return in an instant just like the Russian stock crash in May 2014. For long term dividend investors that can hold on to the volatility it can be a good alternative dividend index fund option for the portfolio.


Chasing International Dividend Yield

SPDR S&P International Dividend (DWX) can be considered for investors looking for international index fund paying dividends. S&P International Dividend Index which DWX tracks is a dividend weighted index of 100 highest yielding non-US companies. It is the smallest ETF by AUM of the 3 examined above but by any standards the day to day liquidity is still good.

DWX invests in internationally across 29 countries. Exhibit below shows the breakdown of the asset under management by country. Australia not surprisingly account for largest position in DWX. Payout ratios of Australian stocks are much higher than US peers because dividends are not taxed at the individual level. Top 10 largest country in the fund account for 71% of the index fund.

DWX Country Allocation - Dividend ETF

Exposure Breakdown

We have shown there are a number of index funds that could provide a steady stream of dividend for investors. The right fund will be based on the exact exposure the investor is looking for and the options presented provide a distinct option each either consistent large cap dividends, portfolio of small cap dividend weighted stocks or international dividend stocks.