How ETF dividends work

Research has shown that since 1926, dividends have contributed nearly a third of total equity return while capital gains have contributed two-thirds. So dividends are an important part of ETF investing. SPY, which tracks the S&P 500, has historically averaged a dividend yield of 1.87%. ETFs that invest in bonds can pay out even higher dividends due to the interest they earn from holding the bonds. If interested, you can view our list of ETFs with high dividend yields.

Mechanics

All exchange traded funds registered with the SEC under the Investment Company Act of 1940 (see ETF mechanics) are required to pay out to shareholders as dividends, at least annually, any net investment income or capital gains. An exchange traded note ("ETN") may or may not pay dividends, as outlined in the ETN's prospectus or explained on the sponsor's website.

Many ETPs pay out dividends more often than annually, as shown in this table:

FrequencyCount
33
363
Annually327
Monthly336
Quarterly790
Semi-Annually175
Total2,024

When an ETP pays a dividend, it can consist of one of four types:

The type of dividend affects the way the dividend is taxed to the investor. Consult your tax advisor for details.

Most dividends from equity and bond ETFs are "ordinary income" stemming from the ETF holding stocks and bonds. When the stocks pay a dividend, or the bonds pay interest, that income is passed along to the ETF's investors in the form of dividends (net of the ETF's fees).

Because of the way that an ETF is structured, most ETFs don't generate a lot of capital gains - see ETF mechanics for why. There are some notable exceptions to this general rule, as detailed below. You can look at the ETF's website for details about every dividend, as to whether it is ordinary income or a capital gain distribution.

Dividend dates

To determine whether you should get a dividend, you need to look at the "ex-dividend date" or "ex-date." If you purchase a stock on its ex-dividend date or after, you will not receive the next dividend payment. Instead, the seller gets the dividend. If you purchase before the ex-dividend date, you get the dividend.

On the ex-dividend date, the market price of the ETF should theoretically decline by the amount of the dividend. Prior to the ex-dividend date, the market price of the ETF should theoretically increase in anticipation of the upcoming dividend.

The "record date" of the dividend is typically two days after the "ex-dividend" date. The U.S. Securities and Exchange Commission states that in order to receive a dividend payment, most often in the form of cash or shares, a shareholder must be on the companyís list of shareholders by the set record date. In order to so, the companyís shares must be bought before the ex-dividend date. The ex-dividend date is set for stocks two business days before the record date, because in the U.S. stock market exchanges are allowed three business days to fully process a stock purchase/sale transaction.

Subsidized Yield

It does not happen very often, but an ETF can pay out more in dividends than is justified by the ETF's actual earnings. The Securities and Exchange Commission requires an ETF to disclose if it has "subsidized yield" by requiring an ETF to make two different disclosures: SEC subsidized yield, and SEC unsubsidized yield. The subsidized yield reflects fee waivers and/or expense reimbursements recorded by the Fund during the period. Without waivers and/or reimbursements, yields would be reduced. The unsubsidized yield does not adjust for any fee waivers and/ or expense reimbursements in effect. If the Fund does not incur any fee waivers and/or expense reimbursements during the period, the SEC subsidized Yield and SEC unsubsidized Yield will be identical.

Let's look at an example. AMZA, the Infracap MLP ETF, paid out dividends in 2016 totaling $2.08 per share. The fund paid a consistent dividend of $.52 per share per quarter. According to the the fund's Annual Report for the year ending October 31, 2016, only 60% of the dividends were "covered" by earnings. The fund had net earnings for the year of $6.9 million yet it paid dividends of $11.8 million. According to the annual report:

The dividend coverage ratio in 2016 was negatively impacted by the rapid growth of the Fundís assets. The rapid growth in shares outstanding with many shares issued just prior to dividend payments meant that some investors were getting 100% of the dividend while the portfolio did not hold the related income-earning securities for 100% of the period leading up to the dividend declaration. The impact of this effect was especially acute in two periods when shares outstanding doubled from the beginning to the end of the period.
Again, this situation happens rarely with ETFs, but investors should be aware that it can happen. At this time, ETFAnalyst.com does not have the ability to automatically and systematically know when this is happening. We wish we did.

Special situations

Special security type ETFs

We have coined the term "special security types" to refer to ETFs that invest in companies and/or securities that by default generate very high dividends. These include business development companies ("BDCs"), master limited partnerships ("MLPs"), real estate investment trusts ("REITs"), closed end funds, and preferred stock. Read our article what are special security types for more information about these ETFs.

Foreign currency hedged ETFs

Many global ETFs use foreign currency hedging in an attempt to minimize the effect of foreign currency swings on the net asset value of the ETF. Most of these ETFs use foreign currency forward contracts to hedge the currency risk. These forward contracts generate gains or losses every month, due to changing foreign currency exchange rates. Any gains generated by these forward contracts are required to be distributed to shareholders as a capital gains distribution, at least annually.

Lately, these currency hedged ETFs have been generating unusually large dividends. These high dividends are difficult to interpret, as explained in our educational article what is a currency hedged ETF?

Leveraged and inverse ETFs

Leveraged and inverse ETFs (not ETNs) do not pay dividends based on the dividends of the index of the stocks or bonds they are tracking. But they nevertheless can still pay out dividends from time to time, sometimes even on a regular basis. That is because leveraged and inverse ETFs can generate a large number of capital gains during the course of buying and selling swaps and other derivatives. They may also generate ordinary income from investing excess cash on hand. See what is a leveraged ETF?

Leveraged High Dividend ETNs

Many leveraged and inverse ETNs do not pay dividends. However, there is a special class of leveraged ETNs that do pay out leveraged dividends based on the underlying index the ETN is tracking, which often results in the ETN having a very high dividend yield. See what is a leveraged high dividend ETN?

MLP ETFs organized as C corporations

MLP investing is a little tricky in the sense that if you own an MLP you are a limited partner, and there are certain accounting and tax burdens that go with that. Some ETFs that invest in MLPs have chosen to be organized as a C corporation, which is unusual for an ETF. These ETFs will pay tax at a corporate (i.e. fund level), which is unusual. When these C corporation ETFs pay a dividend, it is considered to be after tax.

Covered Call Option Writing ETFs

There are a handful of ETFs that use covered call option writing to generate large dividends to shareholders. You have to be careful when analyzing the high dividends of these ETFs because in a sense the dividends aren't really income, because the income was generated at the expense of better performance of the market price itself. This is more fully explained in our educational article option trading ETFs.


All data is a live query from our database. The wording was last updated: 07/27/2017.

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