Dividend ETFs

Dividends have proven their worth as part of the total return for shareholders. A well-respected Barclays Equity Gilt Study shows that the long-term return for £100 invested in the UK All-Share Index between 1899 and 2018 is an impressive £2.7 million. However, strip out dividends and that falls dramatically to under £20,000. Reinvesting dividends to benefit from the effects of compounding is one of the most powerful ways to increase returns over time.

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What is a dividend ETF?

A dividend ETF is an exchange traded fund that tracks the performance of an index or basket of dividend-paying stocks. This is an index such as the FTSE 100 or S&P 500, but screened for those companies paying the highest dividends. The dividends paid out by the ETF can either be rolled up to buy more shares in the ETF or paid out as an income to investors. Dividend ETFs are passively managed, which means the manager will buy and sell only when the index weights change.

How does a dividend ETF work?

Dividend ETFs will track the performance of popular dividend indices. There will be subtle differences between the way these indices work. Some target companies with the highest dividends in the market, while others screen for consistency and longevity of payments. And others focus on companies that have seen the strongest growth in dividends over time. These indices may be weighted by market capitalisation or by the level of dividend and may focus on individual countries or sectors.

Dividend ETFs: payments

When you buy a dividend-focused ETF, you can choose to “accumulate” (reinvest) the income or “distribute” it (pocket the money). If you choose an accumulation strategy, it will be used to buy more shares in the ETF. This can be a good way to harness the power of compounding and grow an investment over time. Either way, the income will be taxed at your marginal rate (the highest rate of tax you pay, perhaps 20%, 40% or 45%). Equally, you may have to pay capital gains tax on a rise in the price of the ETF. If you buy the ETF through an ISA, all income and capital gains are tax-free. Everyone over 18 has a £20,000 annual ISA allowance for the 2023/2024 tax year.

How to choose a dividend ETF

The right dividend ETF for you will depend on your personal investment goals, including whether you need an income from your investments today, the level of income you need and whether you want to prioritise a high or growing income.

Here are the main considerations when buying a dividend ETF:

• The dividend yield. This is how much the ETF pays out in dividends, relative to its share price. This can only ever be a historic measure, but should give you an indication of the level of income you can expect.
• Historic returns. You can look back on how a fund has performed over 1, 3 or 5 years. While this is not a guide to future returns, it should demonstrate how the fund’s strategy has performed relative to its peers and the type of market environment in which it thrives.
• Expense ratio. Costs can cause a drag on your fund returns. Dividend ETFs tend to be slightly more expensive than standard ETFs, but 0.4–0.6% is standard. Any higher and you could get an actively managed fund for the same price.
• Investing strategy. Does the fund invest in small or larger stocks? Does it invest in a single region or across the globe? Does it invest in specific sectors? It can be worth looking at the top 10 holdings in the fund to see if these are the type of stocks you want in your portfolio.
• Risk. In general, dividend-paying stocks tend to be more mature businesses and therefore are “safer” than other areas. However, there will still be a difference between a strategy targeting, for example, small and mid cap stocks versus larger stocks or specific sectors. It is important to be comfortable with the risk you are taking.

Best dividend ETFs in the UK

Here are some of the best dividend UK ETFs according to JustETF:

Icon	Fund	Dividend yield	1-year performance (to 7 March 2023)	Link to invest
	iShares UK Dividend UCITS ETF (IUKD)	6.16%	2.71%	Invest with FreetradeCapital at risk
	L&G Quality Equity Dividends ESG Exclusions UK UCITS ETF (LDUK)	6.02%	5.58%	Invest with IGCapital at risk
	WisdomTree UK Equity Income UCITS ETF (WUKD)	5.80%	3.73%	Invest with SaxoCapital at risk
	SPDR S&P UK Dividend Aristocrats UCITS ETF (Dist) (UKDV)	5.80%	-0.88%	Invest with FreetradeCapital at risk

The effects of compounding over time

Compounding is where you reinvest the money received as dividends so that it can also grow in value, as well as bag you more in dividends next time. This means that you could end up owning more shares as you buy additional shares (or fractions of shares) whenever you reinvest.

For example, take General Mills. We looked at the dividend payments from 27 June 2011 to 28 June 2021. If you had invested $100 (about £73) at the start of the period and reinvested all the dividends you received, by the end of the period you would have had approximately $226.57 (around £165).

This is for illustrative purposes so it’s only approximate – it doesn’t consider the ex-dividend dates.

Bottom line

Dividend ETFs can be a cheap and straightforward way to target income-paying companies. This can help you build a high and growing income from your investments that should protect you against inflation. It is worth noting that income-paying companies tend to be larger, mature businesses and tend to have a higher weighting in industries such as oil and gas or tobacco. As such, they may not score as strongly on environmental, social or governance criteria.

Frequently asked questions