Do you want to invest in index funds but unsure of what the funds do with the dividends they receive? You have come to the right place. In this article, we will look at what both index ETFs and mutual funds do with their potential dividends.
(Yes, both ETFs and mutual funds can be index funds. There seems to be a common misconception that all ETFs are index funds and all mutual funds are actively managed. That’s not the case.)
First off, if and how much dividends an index fund receives depends on the securities it owns. Generally speaking though, most index funds will accrue at least some dividends.
But to directly answer the question: Yes, index funds do pay dividends. How the dividends are distributed depends on the fund itself, and also on whether it’s an ETF or mutual fund.
How do index funds distribute dividends?
There are basically two ways the index funds deal with dividends. The dividends are either:
- Distributed as cash to the shareholders.
- Reinvested in more shares of the fund on behalf of the shareholder.
The two are pretty much the same. If the dividends are automatically reinvested, you can simply sell the shares if you prefer cash. And if you’d rather have more shares, you can just buy it yourself if you received cash.
Below I will show you where to find the document containing all the information you need about a fund. Information like when, and how dividends and capital gains are distributed.
- You go to the site of the investment company that created the fund.
- You go to the specific fund.
- You find the document named prospectus.
- You open it and read the dividend distribution policy.
(Tip when looking for something specific on a page: CTRL + F brings out a search bar in nearly all browsers. You can then type DIVIDEND, or whatever you’re looking for and it will find it.)
How index ETFs distributes dividends
How do index ETFs and mutual funds differ when it comes to dividends?
An index ETF either distributes its dividends as cash to its shareholders or reinvests them in its underlying securities. An important thing to know is that you can’t decide how you want to receive your dividends from a given ETF, it’s predetermined.
So you must choose an ETF that handles dividends in the manner that best suits you.
Note, ETFs that reinvest their dividends can be beneficial if you plan to reinvest the money anyway, since in this way you don’t have to pay any transaction fees. However, they are still taxed as dividends, whether reinvested or not.
(Some brokers can provide their clients with automatic reinvestments even if the ETF itself only distributes dividends as cash.)
How index mutual funds distribute dividends
Unlike with ETFs, when you’re buying index mutual funds, you’re often presented with a choice. You can choose to have your dividends automatically reinvested or to receive them as cash.
However, if you’re investing through an employer-sponsored retirement or savings plan, your dividends will most likely be automatically reinvested in additional shares.
How much do index funds pay in dividends?
So how much will you receive in dividends from investing in index funds? That depends on the index and its underlying securities. I will list some of the most common indexes and their dividend yields further down.
One thing to look out for when investing in funds is the expense ratio. The expense ratio is the annual fee you pay a fund to manage your money. It’s especially important when investing for dividends.
If it’s too high it will eat up much, if not all of the dividends you would receive. Imagine buying a fund with a 3% dividend yield but a 1.2% expense ratio. In that case, you would only receive 1.8%.
Index funds usually carry low expense ratios when compared to other types, though. But since they all just follow indexes, the thing separating two following the same index is the expense ratio. Just make sure you’re not overpaying.
Below is a list of common indexes and their dividend yield.
|EURO STOXX 50||2.6%|
|S&P Asia 50||1.91%|
Capital Gains Distribution
Capital gains are distributed similarly to dividends. They occur when a fund sells a security for a higher price than they bought it for, making a profit.
They are then required by law to distribute these profits to the shareholders. Capital gains are mostly associated with mutual funds and not ETFs. Because of their structure, ETFs generally don’t generate any capital gains.
In most cases, like with dividends, you can choose how you would like the mutual fund to distribute the capital gains. You can either receive them as cash or have them automatically reinvested in shares of the fund.
If you want to know more about index mutual funds and ETFs, go check out my other article comparing them.