Investors who want passive income to grow find broad exposure to dividend-paying companies in ETFs.Getty Images
Investors are often focused on generating passive income with sources ranging from GICs to rental properties.
Dividend stocks are another common strategy. Buying into individual companies that routinely pay out a portion of their earnings to shareholders can be prudent. By grouping such companies, exchange-traded funds (ETFs) offer even broader exposure.
“Dividend ETFs hold a portfolio of stocks that are selected based on their track record of consistent dividend payments and financial stability,” says Caroline Grimont, vice-president of marketing at Harvest ETFs in Oakville, Ont.
The universe of dividend-paying stocks is huge. While the goal is a steady stream of income, the strategies to get there differ.
Some dividend ETFs are actively managed, meaning the stocks are picked based on the portfolio manager’s discretion and selection criteria for the securities. In contrast, passively managed ETFs may be benchmarked to an index such as the S&P Global Dividend Opportunity Index or the Dow Jones U.S. Select Dividend Index. Such ETFs track dividend stocks based on rules-based criteria, says Jaron Liu, director of ETF Strategy at CI Global Asset Management in Toronto.
Funds can place varying degrees of emphasis on stocks with the highest dividend yields (the amount paid, expressed as a percentage of the stock price), the sustainability of dividends, a company’s ability to grow them, quality and size, volatility, or a combination of these factors.
Depending on an ETF’s screening criteria and methodology, Mr. Liu says investors can benefit from fundamental factors that may improve risk-return potential over the long term.
To generate additional income, some ETFs use an active covered-call strategy. Ms. Grimont explains that this involves selling covered-call options – the right to buy shares of a holding in the ETF at a set price on a set date. Call-option buyers pay a premium for the options. “That enhances the income of the ETF, enabling it to pay distributions at higher annualized yields than the cumulative dividends of its holdings,” she says.
Beyond enhanced income potential, dividend ETFs can reduce the risks tied to individual stock selection, Ms. Grimont adds. They provide portfolio diversification by investing in a wide array of dividend-yielding stocks across sectors. She says these companies, which are typically large and financially stable, showcase resilience even during market downturns.
With a pool of dividend-paying stocks, investors also benefit from a more consistent income stream. “If you are investing in individual stocks, payments could be a bit more irregular as companies pay quarterly or annual dividends. Most dividend ETFs pay monthly distributions, providing a smother level of income to investors,” says Chris Heakes, head of Disciplined Equities and portfolio manager with BMO Global Asset Management in Toronto.
With all of their appeal, investing in dividend ETFs is not without risk. “Because they invest in equities, they have many of the same risks as any equity fund, including market risk, interest-rate risk and geopolitical risks,” Mr. Liu says.
Another risk is investing in certain securities that Mr. Heakes calls “yield traps,” where some financially unstable companies offer higher yields to attract investors. But because these companies aren’t financially sound, they may eventually reduce or eliminate dividends.
A dividend-based approach might also mean avoiding certain sectors that typically don’t pay dividends, such as technology companies.
“You want to go underneath the hood to really understand what you are investing in, and the underlying methodology used in selecting stocks,” Mr. Heakes says.