Index funds are mutual funds or exchange-traded funds (ETFs) that hold some or all of the securities as a specific index, such as the S&P 500 or the Barclays Capital U.S. Aggregate Float Adjusted Bond Index. These market indexes measure the performances of selected securities (called a "basket") that is representative of a selected stock market sector or the economy. Index funds track the market index and offer an indirect, economical investment option. The majority of index funds pay dividends to investors.
Index Fund Dividends
Index mutual funds and are regulated by the Investment Company Act of 1940. As investment companies, these funds are required to pay out any interest or dividends earned by a fund's portfolio, minus expenses, as dividends. The majority of index funds will hold some securities that pay dividends or interest. These funds will pay some rate of dividend to investors. The amount of the index fund dividend depends on the type of index fund and the specific tracking index.
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Fund Management Costs
One of the advantages of index funds is the low expenses of these funds when compared to actively managed mutual funds. As of 2020, the average expense ratio for a managed mutual fund is about 0.5 percent. The Vanguard S&P 500 Fund is one of the largest index funds and has an expense ratio of 0.03 percent. A low expense ratio means a fund will pass along a higher portion of the fund's portfolio earnings as dividends.
When Dividends Are Paid
Index funds will pay dividends based on the type of securities the fund holds. Bond index funds will pay monthly dividends, passing the interest earned on bonds through to investors. Stock index funds will pay dividends either quarterly or once a year. Index funds tracking the larger, blue chip stock indexes will have a quarterly payout.
If the index consists of growth stocks will little or no dividends, a fund tracking this index will pay an annual dividend consisting of the dividends the stocks in the fund paid over the year.
Consider Also: Financial Lit: Mutual Funds
How Dividends Are Paid
Investors in index mutual funds can elect to take any dividends paid in cash or have dividends reinvested into more shares of the fund. The reinvestment option helps compound the growth potential of the fund. ETF shares are purchased on the stock exchange through a brokerage account. Dividends from an ETF investment will be deposited into an investor's brokerage account. There is no reinvestment option with ETF index funds.
Income Potential From Dividends
Investors looking for a higher level of income can invest in index funds that specifically target high dividend stocks. The funds will then pass along the dividends earned from the stocks as dividends to the fund investors. Some examples of funds that invest in these stocks include ETRACS Monthly Pay 2xLeveraged U.S. High Dividend Low Volatility ETN Series B (HDLB), UBS AG FI Enhanced Global High Yield ETN (FIHD, ) and First Trust Morningstar Dividend Leaders Index Fund (FDL).
When making decisions about monthly dividend stocks, be sure to consider your options carefully. Take time to do research into your options before you invest and keep in mind that past performance does not necessarily predict how any fund will fare in the future.
Consider Also: Financial Lit: Dividends