Do you like the growth potential of stocks, but get scared by high-flying companies that sometimes fall to Earth? Or maybe you’re looking for income-generating investments, but want better returns than bonds offer? Dividend exchange-traded funds (ETFs) may be worth considering.

　　Dividend ETFs hold a basket of dividend stocks—shares of companies that prioritize periodic payments to shareholders—in a single tradable security. Dividends are paid to shareholders from a portion of the companies’ profits. Many dividend ETFs follow an index, such as the Dow Jones U.S. Dividend 100 Index tracked by the Schwab U.S. Dividend Equity ETF (SCHD), although more actively managed ETFs are coming to market.

　　These ETFs are popular with investors who want steady income and a little growth. They appeal to those looking to transition their portfolios as they move toward retirement. The best dividend-paying ETFs suit your own investment goals and time horizon. Keep in mind that dividend payments aren’t guaranteed, but dividend ETFs help spread out the risk.

　　Why invest in dividend ETFs?The allure of passively watching income payments hit your investment account is enticing. Owning dividend ETFs can be a winning strategy for workers nearing retirement looking for long-term growth, a steady income stream, and capital appreciation.

　　Unlike owning individual dividend-paying stocks, dividend ETFs (and their counterpart, dividend mutual funds) hold numerous stocks in a single trading vehicle that investors can easily buy and sell. Dividend ETFs and mutual funds share much in common, but they have a few key differences.

　　Usually follow a passive index, but some are actively managedGenerally have lower fees than mutual fundsCan be traded throughout the dayThe cost is the price of a shareDifficult to set up automatic purchase plansDividend mutual funds

　　Usually actively managedSlightly higher fees than ETFsTrade only once a dayMay have a minimum investment costSetting up an automatic dollar cost averaging plan is easyDividend ETFs may hold companies from any sector, but generally, they include staid businesses that grow slowly or have consistent earnings. Examples include consumer staples (such as food producers), utilities, communication services, some health care, and traditional energy stocks. These sectors usually have slower growth, so they offer dividend payments to entice investors. 

　　Types of dividend ETFsInvestors new to dividend ETFs might zero in on a juicy yield, but before you buy, it’s key to know why that yield is so high. Dividend ETFs are divided into two main categories: growth and high-yield dividends.

　　Dividend growers: These ETFs focus on companies with a history of raising their dividends over time and may have a lower current yield. These stocks balance ongoing growth and payments on top of capital appreciation, and they emphasize sustainable payments over high income. Certain dividend-growing companies are known as dividend aristocrats; these are S&P 500–listed companies that have increased the dividend paid to shareholders annually for 25 consecutive years. One ETF that holds such shares is ProShares S&P 500 Dividend Aristocrats ETF (NOBL).High-yield dividend: These ETFs prioritize higher dividend yields; the focus is on immediate income, rather than a history of growing the dividend over the long term. Note that higher-than-average dividend payments may not be sustainable—some financially challenged companies offer high dividends. Schwab U.S. Dividend Equity ETF (SCHD) is a high-yield dividend ETF.When choosing among dividend ETFs, read the fund’s strategy and its objective, including whether it follows an index or is actively managed. That information is found on the fund’s website and in more detail in the prospectus.

　　How dividend ETFs pay incomeIncome generated by dividend ETFs is distributed in two ways:

　　Cash payments. Retirees seeking to live off the income generated by dividend ETFs can get distributions paid directly to their brokerage accounts.Reinvesting. Many dividend ETFs offer a dividend reinvestment plan, known as a DRIP, which allows holders to automatically funnel the dividends into more ETF shares. The benefit of selecting a DRIP is compounding returns, which can increase how many shares you own over time.ETFs in general are known for their tax efficiency, but that isn’t necessarily the case for dividend ETFs. Income generated by dividend ETFs may be subject to taxation, depending on where they are held—in a taxable or tax-sheltered account—and the tax rate varies depending on whether the ETF holdings are considered qualified or nonqualified dividends. You may get a tax bill even if you decide to reinvest the income from nonqualified dividends held in a taxable account.

　　Although dividend ETFs offer a steady income stream, remember that dividend payments aren’t guaranteed. Companies may cut or eliminate dividends for several reasons, such as financial challenges, business strategy changes, or recessions. Many companies cut dividend payments during the financial crisis of 2007–08 and in response to the market slide caused by the COVID-19 pandemic in 2020.

　　When a company cuts its dividends, it may signal internal issues. But owning a dividend ETF may help shield you from individual company stress because these funds own many stocks, spreading out the risk.

　　The bottom lineDividend ETFs are an easy way to invest in numerous dividend-paying companies with a single vehicle. They’re popular with those nearing retirement who want to reduce the risk associated with holding single stocks, but stay invested and earn some income. Reducing risk doesn’t eliminate it, since all investing involves some risk. There are many dividend ETFs, so read the funds’ prospectuses and compare their holdings to help determine which funds suit your investing style. If you’re looking for a steady income stream while possibly benefiting from market growth and capital appreciation, dividend ETFs may be a good fit for your portfolio.