ETFs Made Easy: Dividends Vs Total Return

Which is better, banking on a dividend or on price appreciation?

Reviewed by: Dave Nadig
Edited by: Dave Nadig

Which is better, banking on a dividend or on price appreciation?

In this series, we answer the questions investors are afraid to ask. You can submit your questions to me at [email protected]. All correspondence will remain anonymous.

This question came into my email box yesterday morning, and it’s too good not to answer:

“What’s the difference between putting all your money in a dividend-producing ETF and ‘living off the dividends versus buying an ETF that appreciates and living off the appreciation—assuming the same total return?

I imagine taxes are the answer—but some articles (and advisors) act like there’s some magical benefit to ‘living off the 3% dividends’ versus living off the 3 percent appreciation. Is it just a psychological difference (that vanishes quickly in a bear market) or something else?”

The answer to this question comes down to two things: convenience and taxes.

Lets start with this exact example: Let’s imagine two hypothetical ETFs. CASH costs $100 and pays out $3 in dividends next year. GROW costs $100 and grows to $103 next year, but pays no dividends at all.

  • If I have these two ETFs in my individual retirement account, then the difference here is entirely one of convenience. Both ETFs have the exact same return. The only question is whether I want to withdraw cash from my account or stay fully invested. If I don’t need the cash and I want to stay invested, GROW is the way to go: After all, I have to do exactly nothing and my money keeps humming along. With CASH, I’d have to reinvest the $3 in dividends, which would cost me commissions, spreads, etc.

    Conversely, if I need the money to pull out of my IRA, I’m better with CASH: It saves me the hassle of selling shares to raise $3.

  • If I have these two ETFs in my taxable account, things get more complicated. With CASH, it all comes down to how the dividends I get are classified. If they are “qualified” dividends, which most dividends from equity ETFs are, that means I can get special tax treatment, and pay a maximum of 20 percent on the distribution. If they’re considered just “ordinary” dividends—perhaps from a bond fund—I’ll pay my regular old income tax rate; that’s a big difference. And I’ll pay that tax whether I really need the dividend or not, and will have to reinvest if it turns out I don’t. With GROW, I can choose to sell some or not, and as long as I’ve held it for a year or more, I pay capital gains taxes of 20 percent.

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In the above two scenarios, neither is clearly better for all investors, and the difference in tax treatment and withdrawal needs is critical.

But there’s a little more to the story. Companies tend to think of their dividend payments not as a percentage, but as a dollar figure, and companies that have a long history of steady or increasing dividends will often move heaven and earth to keep paying that dividend to their investors.

That means that even if the stocks in CASH decline in value by 10 percent, there’s a very good chance that the ETF will still have dividends to distribute. Barring real economic hardship for the companies it holds, there’s a good reason to suspect that payment will be close to $3, regardless of whether the market is up or the market is down.

If you’re planning on needing that $3 a year, that makes many investors feel safer with the somewhat “known” dividend they expect than just counting on the vagaries of stock market performance for short-term cash needs.

True dividend believers will also claim that a steady dividend history is the sign of a company unlikely to get into trouble—a kind of shorthand for financial stability. There’s plenty of room for debate on that topic, but it’s all part of the “magical benefit” that the email spoke of.

You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.

Prior to becoming chief investment officer and director of research at ETF Trends, Dave Nadig was managing director of Previously, he was director of ETFs at FactSet Research Systems. Before that, as managing director at BGI, Nadig helped design some of the first ETFs. As co-founder of Cerulli Associates, he conducted some of the earliest research on fee-only financial advisors and the rise of indexing.