Yes, index funds certainly pay dividends if the underlying index pays dividends. However there are some nuances by country, and a few other points you’ll need to keep in mind if this is the route you wish to take.
Investing in index funds holds plenty of advantages. To start, you can expect easy diversification of your money without having to hunt around for new investments. What’s more, the returns-to-fees ratios on index funds are generally desirable. Let’s dive in and look at some of the key things you need to keep in mind regarding index funds and dividends.
Index funds and dividends – how do they work?
We have discussed at length in a prior article on the similarity and differences between index funds and ETFs. In a nutshell, index funds are ETFs in the wrapper of a mutual fund. This means that index funds, just like an ETF, track an underlying index such as the S&P 500, the Nasdaq, or the FTSE 100.
Therefore, as long as the underlying index offers a dividend, an index fund that tracks said index will offer a dividend as well. You do however need to pay attention to whether the fund provider offers various flavours of the same fund.
Due to regulatory reasons and the way in which the markets developed in each region, there are some differences in the way index funds offer dividends. It’s nothing too complicated, but nevertheless important to understand, so that your portfolio delivers what you want – income or growth.
US & Canada
In the US and Canada, there is only one flavour of an index fund. If the underlying index pays a dividend, then the fund will do so too. However you do have the option of getting your dividend reinvested to buy more units of the same fund. You would do this by issuing standing instructions to your broker to reinvest the proceeds once you receive them.
If you choose to keep your dividends in cash, you’ll notice your cash balance go up once you receive the dividend. If you choose to reinvest the proceeds, you will instead notice the number of units held of the underlying index fund increase over time. As you can buy fractional units of an index fund, you do not have to worry about having any cash left over at the end of the day.
The benefit of reinvesting the dividends is that your reinvested cash will then also grow at the market rate, instead of just sitting in the account with mostly negligible returns. However if you need the cash for your living purposes, then of course you don’t want to reinvest those dividends.
In both cases, taxes will apply to the dividends at your applicable rates.
UK & Europe
In the UK and EU, index funds are offered in a “distributing” and “accumulating” flavours. For example, Vanguard in the UK offers two flavours of their Global Equity Fund – VAGLEGA and VAGLEGI. As you may be able to guess based on the last letter in the fund names, VAGLEGA is an accumulating fund whereas the VAGLEGI is a distributing fund. The distributing version pays a regular dividend, which in this case is on an annual frequency. In the accumulating fund, the proceeds are retained within the fund and reinvested in to the holdings.
Due to the difference in the payout structure, the two versions of the funds will have different NAVs (the price of each unit of an index fund or mutual fund is called a NAV). As the accumulating versions retain the cash, their NAV will be higher than the corresponding distributing version.
We can verify this by comparing the two funds we have looked at. The accumulating version, VAGLEGA, has a NAV of £223.23 whereas the distributing version, VAGLEGI, has a NAV of £209.84. VAGLEGA has a higher value as it not only retains, but reinvests the dividends which then compound over time.
The one common theme across the world is income taxes. Dividends are subject to income taxes, but the rates will vary based on the jurisdiction. If you hold the funds in a “normal” account, those dividends will be subject to the full tax rate.
If you however hold the funds in a tax-sheltered or tax-deferred account, your dividends will be shielded from taxes. Examples of such accounts include the Roth IRA and 401k in the US, the TFSA and RRSP in Canada, and ISAs or SIPPs in the UK.
Do index funds pay dividends regularly?
Yes, index funds do pay dividends regularly. As with all dividends, the number of times you can receive these payments will vary from fund to fund. Overall, you can expect to receive dividend payments from index funds either once a year (annually), twice a year (semi-annually), four times a year (quarterly), or once a month (monthly). Again, it all ultimately depends on the underlying index as the index fund will follow whatever the underlying index does.
This payment frequency isn’t a choice you can make, unless you choose to invest with an index fund working to a specific pattern ahead of time. For example, some stock index funds may choose to pay quarterly, while others (with bond attachments, for example), monthly. It’s wise to check these schedules before investing any money of your own so you can plan ahead.
Now – it’s easy to budget for this as income if you’ve invested in a fund that’s not particularly volatile. However, given that stock values change and that industries react wildly to sudden economic shifts, there’s never any guarantee of what you might receive.
A tool like Personal Capital or Mint can help you with tracking your income.
What should you look for in index funds that pay dividends?
As with any investment, you should first look for funds that aim to deliver the best return profile while managing risk. Additionally, you should ensure that these funds are best suited for your risk and tolerance, and that they fit inside your asset allocation strategy. Moreover, where dividends are concerned, you should remember to not sacrifice total returns at the alter of a high dividend yield.
If all of this sounds too complicated, I advise seeking an investment advisor for help. Alternatively an online platform, app, or robo-advisor can help you choose between dividend payments, reinvestments, and other types of portfolio growth. Much of the decision you make, of course, will result from your attitude and flexibility regarding risk.
Let’s take a high level look at some of the parameters that you should keep in mind.
Dividend yields on index funds inform you of how much you can hypothetically earn based on a fund’s price at any given payout period. For example, your wield may set at 3.3%.
Naturally you’d expect that the higher the dividend yield percentage you receive, the better. However this may not always be the case. That said, you may find the ‘safer’ funds out there offer smaller yield percentages. It’s wise to balance both options when looking around.
Risk Levels or Ratings
Risk levels, too, are good to keep in mind before investing. Depending on the brokerage or investment service you choose, some index funds may already have ‘risk ratings’ attached to help you make a comfortable decision.
Please note that, it’s important to not chase the fund with the highest dividend yield. There are no free lunches in this world, and often a high dividend yield might be generated from companies that don’t have much growth prospect or that may actually be in decline. Similarly for bonds, high yielding bonds are often from companies that have a very bad risk profile.
While many expect that higher risk profiles will drive higher potential returns on index fund dividends, it’s not always the case. Potential returns are just that – ‘potential’ returns. If higher risk always led to higher returns, then paradoxically, the risk would actually be low! People always think about the upside potential (“high” returns) but often forget that high risk means that there is an equal or probably a greater chance of “high” losses too!
It’s therefore important to ensure that the underlying fund invests in and generates its dividends from high quality companies and well rated bonds. If you’re new to index funds and even dividends in general, always lean towards lower-risk funds first and follow the advice of your human or robo advisors.
Do also look into expense ratios. An index fund’s expense ratio gives you a clear idea of how much of any given fund’s assets pay towards the cost of keeping a company running. It’s another set of numbers that prove useful when you want to calculate how much money you could make in the long run.
Typically index funds have a very low expense ratio in comparison to an actively managed mutual fund, so you’ll have that going for you. If the difference between the fee on two index funds is less than 0.5%, I would treat those two as very close to the same then.
Is it worth claiming dividends on index funds?
In many ways, claiming dividends can prove lucrative for investors placing money into index funds. However, you should never rely on their value wholesale or expect a specific amount all the time. Just like stocks, as an index fund’s value fluctuates with time and economic cycles, the dividend paid out over time can potentially vary.
Dividends can prove highly useful if you wish to grow and diversify this type of return in other funds or stock. For example, you may reinvest one fund’s dividend income in another or even several others. Once you’re more acquainted with how index funds and dividends work, this can be a lucrative way to grow despite inflation.
That said, many people have different preferences when it comes to investments. Many see index funds as safer than stock investments outright as they benefit from immediate diversification. Dividends, too, are seen as safe returns as you always get a guaranteed return – the amount, however, will always vary.
by Brianna Johnson
Brianna Johnson, a Miami-based finance veteran, is a wealth advisor for high net-worth families. She loves to write and to share her knowledge. For PFF, she writes in-depth articles on finance and investments that help readers get unique insights. See more.