Index funds are mutual funds or exchange traded funds (ETFs) that hold the same securities as a specific index, such as the S&P 500 or the Barclays Capital U.S. Aggregate Float Adjusted Bond Index. Index funds provide a low-cost way to invest in specific markets or sectors. The majority of index funds pay dividends to investors.
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 dividend depends on the type of index fund and the specific tracking index.
One of the advantages of index funds is the low expenses of these funds when compared to actively managed mutual funds. The average expense ratio for a managed mutual fund is about 1 percent. The Vanguard S&P 500 Fund is one of the largest index funds and has an expense ratio of 0.18 percent. A low expense ratio means a fund will pass along a higher portion of the fund's portfolio earnings as dividends.
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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.
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 investors brokerage account. There is no reinvestment option with ETF index funds.
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. A couple of examples are the iShares Dow Jones Select Dividend Index Fund. This ETF has the stock symbol DVY and in November 2010 had a distribution yield of 3.73 percent. The Vanguard High Dividend Yield Index Fund Investor Shares is an index mutual fund and had a distribution yield of 2.63 percent.