Although exchange-traded funds (ETFs) are primarily associated with index-tracking and growth investing, there are many that offer income by owning dividend-paying stocks. When they do, they collect the regular dividend payments and then distribute them to the ETF shareholders. These dividends can be distributed in two ways, at the discretion of the fund's management: cash paid to the investors or reinvestments into the ETFs’ underlying investments.

The Timing of ETF Dividend Payments

Similar to an individual company's stock, an ETF sets an ex-dividend date, a record date, and a payment date. These dates determine who receives the dividend and when the dividend gets paid. The timing of these dividend payments are on a different schedule than those of the underlying stocks and vary depending on the ETF.

For example, the ex-dividend date for the popular SPDR S&P 500 ETF (SPY) is the third Friday of the final month of a fiscal quarter (March, June, September, and December). If that day happens to not be a business day, then the ex-dividend date falls on the prior business day. The record date comes two days prior to the ex-dividend date. At the end of each quarter, the SPDR S&P 500 ETF distributes the dividends.

Each ETF sets the timing for its dividend dates. These dates are listed in the fund's prospectus, which is publicly available to all investors. Just as like any company's shares, the price of an ETF often rises before the ex-dividend date—reflecting a flurry of buying activity—and falls afterward, as investors who own the fund before the ex-dividend date receive the dividend, and those buying afterward do not.

Dividends Paid in Cash

The SPDR S&P 500 ETF pays out dividends in cash. According to the fund’s prospectus, the SPDR S&P 500 ETF puts all dividends it receives from its underlying stock holdings into a non-interest-bearing account until it comes time to make a payout. At the end of the fiscal quarter, when dividends are due to be paid, the SPDR S&P 500 ETF pulls the dividends from the non-interest-bearing account and distributes them proportionally to the investors.

Some other ETFs may temporarily reinvest the dividends from the underlying stocks into the holdings of the fund until it comes time to make a cash dividend payment. Naturally, this creates a small amount of leverage in the fund, which can slightly improve its performance during bull markets and slightly harm its performance during bear markets.

Dividends Reinvested

ETF managers also may have the option of reinvesting their investors' dividends into the ETF rather than distributing them as cash. The payout to the shareholders can also be accomplished through reinvestment in the ETF’s underlying index on their behalf. Essentially it comes out to the same: If an ETF shareholder receives a 2% dividend reinvestment from an ETF, he may turn and sell those shares if he'd rather have the cash.

Sometimes these reinvestments can be seen as a benefit, as it does not cost the investor a trade fee to purchase the additional shares through the dividend reinvestment. However, each shareholder’s annual dividends are taxable in the year they are received, even if they are received via dividend reinvestment.

Taxes on Dividends in ETFs

ETFs are often viewed as a favorable alternative to mutual funds in terms of their ability to control the amount and timing of income tax to the investor. However, this is primarily due to how and when the taxable capital gains are captured in ETFs. It is important to understand that owning dividend-producing ETFs does not defer the income tax created by the dividends paid by an ETF during a tax year. The dividends that an ETF pays are taxable to the investor in essentially the same way as the dividends paid by a mutual fund are.

Examples of Dividend-Paying ETFs

Here are five highly popular dividend-orientated ETFs.

SPDR S&P Dividend ETF

The SPDR S&P Dividend ETF (SDY) is the most extreme and exclusive of the dividend ETFs. It tracks the S&P High-Yield Dividend Aristocrats Index, which only includes those companies from the S&P Composite 1500 with at least 20 consecutive years of increasing dividends. Due to the long history of reliably paying these dividends, these companies are often considered to be less risky for investors seeking total return.

Vanguard Dividend Appreciation ETF

The Vanguard Dividend Appreciation ETF (VIG) tracks the NASDAQ U.S. Dividend Achievers Select Index, a market capitalization-weighted grouping of companies that have increased dividends for a minimum of 10 consecutive years. Its assets are invested domestically, and the portfolio includes many legendary rich-paying companies, such as Microsoft Corp. (MSFT) and Johnson & Johnson (JNJ).

iShares Select Dividend ETF

The iShares Select Dividend ETF (DVY) is the largest ETF to track a dividend-weighted index. Similar to VIG, this ETF is completely domestic, but it focuses on smaller companies. Roughly one-third of the 100 stocks in DVY's portfolio belongs to utility companies. Other major sectors represented include financials, cyclicals, non-cyclicals, and industrial stocks. 

iShares Core High Dividend ETF

BlackRock's iShares Core High Dividend ETF (HDV) is younger and uses a smaller portfolio than the company's other notable high-yield option, DVY. This ETF tracks a Morningstar-constructed index of 75 U.S. stocks that are screened by dividend sustainability and earnings potential, which are two hallmarks of the Benjamin Graham and Warren Buffett school of fundamental analysis. In fact, Morningstar's sustainability ratings are driven by Buffett's concept of an "economic moat," around which a business insulates itself from rivals. 

Vanguard High Dividend Yield ETF

The Vanguard High Dividend Yield ETF (VYM) is characteristically low-cost and simple, similar to most other Vanguard offerings. It tracks the FTSE High Dividend Yield Index effectively and demonstrates outstanding tradability for all investor demographics. One particular quirk of the weighting method for VYM is its focus on future dividend forecasts (most high-dividend funds select stocks based on dividend history instead). This gives VYM a stronger technology tilt than most of its competitors. 

Other Income-Oriented ETFs

In addition to these five funds, there are dividend-focused ETFs that employ different strategies to increase dividend yield. ETFs such as the iShares S&P U.S. Preferred Stock Index Fund (PFF) track a basket of preferred stocks from U.S. companies. The dividend yields on preferred stock ETFs should be substantially more than those of traditional common stock ETFs because preferred stocks behave more like bonds than equities and do not benefit from the appreciation of the company's stock price in the same manner.

Real estate investment trust ETFs such as the Vanguard REIT ETF (VNQ) track publicly traded equity real estate investment trusts (REITs). Due to the nature of REITs, the dividend yields tend to be higher than those of common stock ETFs.

There are also international equity ETFs, such as the Wisdom Tree Emerging Markets Equity Income Fund (DEM) or the First Trust DJ Global Dividend Index Fund (FGD), which track higher-than-normal dividend-paying companies domiciled outside of the United States.

The Bottom Line

Although ETFs are often known for tracking broad indexes, such as the S&P 500 or the Russell 2000, there are also many ETFs available that focus on dividend-paying stocks. Historically, dividends have accounted for somewhere near 40% of the total returns of the stock market, and a strong dividend payout history is one of the oldest and surest signs of corporate profitability.