Investors of all kinds have learned that exchange-traded funds can be a great way to invest. ETFs offer the opportunity to get diversified exposure to a wide range of investments in a single fund, and investors have put trillions of dollars to work within hundreds of different ETFs. There are several attractions to ETFs, ranging from the ability to invest extremely small amounts prudently and efficiently to their relatively low costs and their flexibility in allowing investors to buy and sell shares almost whenever they want. You can also find ETFs that cover just about any portion of the investment universe on which you want to focus.

Dividend stock investors have discovered the power of exchange-traded funds, and they've put tens of billions of dollars into a handful of ETFs that focus exclusively on dividend-paying stocks. The five dividend ETFs discussed here take varying approaches toward investing in the dividend stock arena, but they all have healthy dividend yields that reward their shareholders with reliable income. Moreover, they also have the capacity to see their share prices grow over time, adding capital appreciation to dividend income to produce even more attractive total returns. We'll go into more depth about these funds later on, but first, let's look more closely at why exchange-traded funds have seen a boom in popularity and how we narrowed down an extensive list of dividend ETFs to find these five top candidates.

White mosaic tiles spelling ETF on a background of yellow mosaic tiles.

Image source: Getty Images.

What are ETFs, and why are they so popular?

Exchange-traded funds are pools of investment assets that trade on major stock exchanges and offer the chance for investors to buy shares corresponding to a fractional interest in the assets the fund owns. Most ETFs track indexes of various investments, with the goal of matching the return of the benchmarks that they track less the expenses of running the fund.

There are several reasons ETFs have become so popular. First and foremost, ETFs let investors who don't have a lot of money to invest build a diversified portfolio. With even a single share of an exchange-traded fund, an investor can obtain exposure to hundreds or even thousands of different stocks. Rather than having to take limited investment capital and invest it all in one or two stocks, opening yourself up to the risk that the stocks you pick drop precipitously in value, an ETF offers a lot more protection against the single-company risks involved when you buy individual stocks.

Second, ETFs are available to give you the ability to invest in nearly any asset you want. You can find ETFs that target stocks, commodities, bonds, foreign exchange, and a host of other investment assets. Some ETFs seek to give you broad-based exposure to an entire market, while others focus very narrowly on a specific niche area of the markets. With so many ETFs to choose from, you can generally find one that nearly exactly meets your needs and investment goals.

Third, ETFs tend to be relatively inexpensive to own. Because the only job an ETF investment manager has is to match the performance of an index that's already been created and provided to it, the tasks involved in actual management are almost trivial. That gives ETFs much lower expense ratios (the percentage of fund assets that go every year toward covering the fund's costs) than similar pooled investments like traditional mutual funds. You do typically have to pay commissions to buy and sell ETF assets, but some providers offer commission-free ETF trades, and with discount brokers offering rock-bottom commission rates, the costs involved in trading ETFs are fairly low.

Additionally, ETFs are available to trade at convenient times. You can buy or sell ETF shares whenever the market is open. By contrast, mutual funds only let you buy and sell shares once a day as of the close of the market's ordinary trading hours. ETFs let you respond to market-moving news more quickly rather than making you wait until the end of the trading session to lock in your strategic investment moves.

Finally, ETFs have some tax advantages over mutual funds. These advantages can be especially valuable for those who invest in dividend ETFs, because dividend stocks themselves have preferential tax treatment over other types of investment assets that add to their attractiveness.

Why is dividend income attractive?

Dividend stock investors like the income their portfolios generate. The most obvious reason for that is that many people who own dividend stocks actually rely on their dividend income to provide cash for living expenses and other immediate financial needs. Without the dividends these stocks produce, investors would have to resort to other, less attractive income-producing alternatives like bonds, which don't offer the same opportunities for potential growth that dividend stocks have.

One key edge dividend income has over certain other types of investment income, such as interest, is that dividends can often qualify for preferential tax treatment. Qualified dividend income gets taxed at a lower tax rate than most other types of income, with maximum tax rates of 0%, 15%, and 20% applying at various income levels. For the most part, if you're in the 10% or 12% tax bracket under the new tax reform laws, then your dividend income will be tax-free. Those in the 22% to the lower part of the 35% tax bracket will generally pay 15% in tax on their qualified dividend income, while those in the upper portion of the 35% bracket and in the top 37% bracket will pay 20% in dividend taxes.

What are the tax implications of investing in dividend ETFs?

Dividend ETFs give their shareholders the same low-rate tax advantages that those who invest directly in dividend-paying stocks get. The income that the fund earns gets passed through to its shareholders in the form of dividend distributions, and how those distributions get taxed is identical to the way that direct shareholders of the stocks the ETF owns would get taxed. In other words, if you're in one of the two lowest tax brackets and you receive distributions of dividend income from your ETF, then you'll enjoy the same 0% tax rate you would have paid if you'd owned the same stocks that the dividend ETF owns.

Dividend ETFs also have a tax advantage over traditional mutual funds that invest primarily in dividend stocks. When regular mutual funds decide to make shifts to their underlying stock portfolios by selling some stock holdings and replacing them with other stocks, the funds generate capital gains that they then have to pay out to their mutual fund shareholders as capital gains distributions. Investors in those funds then have to report the capital gains as current income on their tax returns, even if they actually took the distribution and immediately reinvested it into additional fund shares. This can result in a major tax hit that unfairly penalizes long-term shareholders in mutual funds.

ETFs don't have the same issue for a couple of reasons. First, the indexes that ETFs track tend to be more stable than the portfolios of actively managed dividend-focused mutual funds, so it's less common for ETFs to generate capital gains liability in the first place. Second, the structure of ETFs allows fund managers to make changes in a way that avoids fund shareholders having to include any amounts as capital gains on their tax returns. That technical difference can produce big savings for ETF investors at tax time compared to their mutual fund counterparts.

A simple, 4-step approach to finding top dividend ETFs

There are dozens of different dividend ETFs, so finding the best one for you might seem like a major challenge. However, the wide array of available dividend ETFs makes it more likely that if you have a particularly unusual angle in your investment strategy, you'll be able to find a fund that will match up with your particular wishes. For example, one ETF focuses exclusively on technology stocks that pay healthy dividends, while another owns only shares of mid-sized companies located outside of the U.S. market.

Most investors don't have such specific tastes in dividend stocks and just want a simple approach to finding high-quality dividend ETFs that will give them solid returns and reliable dividend income. If you're one of them, this four-step approach should serve you well:

  • Step 1: Concentrate on dividend ETFs that take a broad-based approach toward giving you exposure to a wide range of dividend stocks. Smaller niches tend to see much more volatile performance as certain sectors or subsectors of the market move in and out of favor, while broader-based dividend ETFs track the overall market more closely. Moreover, niche dividend ETFs tend to own fewer stocks and are therefore more vulnerable when one of their holdings suffers a massive decline.
  • Step 2: Weed out higher-cost ETFs. With an index approach, many ETFs are available that have expense ratios of less than 0.10%, meaning you'll pay $10 or less every year in expenses for every $10,000 you have to invest. Although it's not essential to get your expenses below that 0.10% level, there's no reason to come close to paying the 1% or more that many actively managed mutual funds charge.
  • Step 3: Decide whether you want to focus on maximizing current income or on seeking faster long-term dividend growth rates. Many dividend ETFs simply pick the stocks that will pay the highest current dividend yields. That can give you the most income right now, but some high-yield dividend stocks have fundamental challenges that, in some cases, can lead to reduced dividend payments in the future. By contrast, some lower-yielding dividend stocks have better track records of consistently boosting the amount they pay shareholders in dividends. If you have a long time horizon and don't necessarily need as much income right now, these dividend-growth-oriented ETFs can deliver more dividend income in the future, when you need it more.
  • Step 4: Look for deals to reduce your commission costs. Some brokerage companies either offer their own proprietary ETFs or have partnerships with outside ETF providers to offer fund shares on a commission-free basis. This can be especially valuable for those who intend to make regular investments on a monthly or quarterly basis, because otherwise, even modest commissions can take away a substantial fraction of the money you have to invest.

Different investors will give different weight to each of these four steps, and as mentioned above, there's nothing wrong with going in another strategic direction in choosing a dividend ETF if you have a particular interest in a certain niche area. The following five dividend ETFs all fare well using this approach, and they each have their own unique approach to dividend investing that can distinguish them from their peers in valuable ways.

5 top dividend stock ETFs

Dividend ETF

Current Dividend Yield

Expense Ratio

iShares Select Dividend (NASDAQ:DVY)

3.5%

0.39%

Vanguard High Dividend Yield (NYSEMKT:VYM)

3.1%

0.08%

Schwab U.S. Dividend Equity (NYSEMKT:SCHD)

3%

0.07%

SPDR S&P Dividend (NYSEMKT:SDY)

2.4%

0.35%

Vanguard Dividend Appreciation (NYSEMKT:VIG)

2%

0.08%

Data source: Fund providers.

iShares gives a top-yielding alternative

If you want a high current dividend yield, it's hard to do better than the iShares Select Dividend ETF. The fund's 3.5% yield compares quite favorably with the overall market's average yield of about 2%, and the ETF has managed to produce an average total return of about 12% annually over the past five years. Investors have a lot of confidence in the fund, having invested almost $17 billion in ETF shares.

The way the iShares ETF manages to emphasize high-yield stocks so effectively is embedded in the philosophy that its underlying benchmark follows. Select Dividend tracks the Dow Jones U.S. Select Dividend Index, which is composed of just 100 stocks. That's a comfortably concentrated portfolio that's in line with most of the other ETFs on this list, but one other innovation that iShares uses is that it doesn't employ a traditional market capitalization-weighted formula for determining how much of each of the 100 stocks to buy. Instead, it weights its components by their dividends, giving greater weight to the stocks that are more generous in sharing dividend income with their shareholders.

iShares ETFs are also well-known for their trading liquidity. With frequent use from institutional investors, you can buy and sell iShares ETFs more efficiently, saving you money whenever you trade. The only downside is that previous deals to make the ETF commission-free at Fidelity and TD Ameritrade appear to have lapsed, offsetting any savings from more liquid shares, although a recent deal at Firstrade offers shares commission-free.

Vanguard's high-yield entry

Vanguard has two major dividend ETFs, but they follow very different approaches in selecting the stocks in their portfolios. The higher-yielding Vanguard High Dividend Yield ETF uses what most would see as the more conventional approach of concentrating on stocks that currently have relatively high dividend yields compared to their peers. That approach involves the fund owning almost 400 different dividend stocks that together produce a yield of just over 3%. Investors have put $20.5 billion toward ETF shares, and they've enjoyed annual average returns of 11.9% over the past five years. That's a bit less than the iShares offering, but it also reflects the lower risk of having an unusually large portfolio of dividend stocks under its umbrella in comparison to most of the ETFs on this list.

The FTSE High Dividend Yield Index, which High Dividend Yield tracks, includes the U.S. stocks that have the highest yields among the large-cap stocks that index manager FTSE has in its tradable stock universe. The index has a more common market-capitalization weighted mechanism for determining how much money is invested in each of the stocks in the portfolio. Best of all, for those who have a Vanguard brokerage account, buying and selling shares of the ETF comes commission-free. Trading volumes aren't quite as high as for the iShares fund, but the commission savings can be a nice offsetting factor to anything extra you might have to pay because of lower liquidity when you trade shares.

Staking out the lowest-cost position

Schwab weighs in with a dividend ETF that has the lowest expense ratio of any among the top dividend ETFs in the market. The U.S. Dividend Equity ETF charges just $7 per year for every $10,000 you have invested in ETF shares, beating out the Vanguard ETFs on this list by $1 and producing dramatic savings over the iShares and SPDR funds. As a relatively new fund, the Schwab dividend ETF has taken time to draw assets, but it's still been successful in pulling in $7.4 billion from investors. The lower fees have shown up in its returns, which have averaged 12.2% annually over the past five years.

Like the iShares ETF, Schwab's dividend ETF tracks an index of about 100 stocks. The Dow Jones U.S. Dividend 100 Index uses a mixed approach that requires both relatively high yields and a long-term track record of dividend growth. Stocks must have paid dividends for at least 10 years in order to qualify for consideration, and the index provider also looks at other factors like return on equity and the strength of the underlying company's balance sheet in deciding whether a stock deserves to be among the 100 in the portfolio. The amount of liquidity doesn't match up to the larger funds on this list, but Schwab brokerage clients get to buy and sell shares of the ETF on a commission-free basis along with the other funds in Schwab's ETF family.

Banking on dividend aristocracy

The SPDR family of funds is another well-known leader in the ETF space, and SPDR S&P Dividend takes an approach that truly emphasizes dividend growth over current yield. Rather than focusing on current yield, the SPDR Dividend ETF only includes stocks that meet the standards of a popular benchmark called the High Yield Dividend Aristocrats Index. In order to qualify, a stock needs to have gone at least 20 straight years of not only paying a dividend, but growing the amount of that dividend every single year. There aren't many stocks that meet those requirements, so the fund has a select portfolio of just over 100 holdings. Investors like the approach, having invested more than $15 billion in the ETF, and returns of 11.7% annually on average over the past five years are in line with its peers.

That doesn't mean the SPDR fund doesn't give those who need current dividend income a reasonable payout. A current yield of 2.4% is still above the market average, which is impressive when combined with the promise of future dividend growth. However, because SPDR doesn't have a brokerage company of its own, it's hard to find SPDR shares on a commission-free basis. A new offer from Firstrade has put the fund on its commission-free list, but apart from that, most major brokers charge a commission to buy and sell the SPDR Dividend ETFs shares, and its annual expenses are relatively high as well.

Vanguard's answer to dividend growth

Vanguard's second ETF looks to address the same issues as the SPDR fund by emphasizing dividend growth. Vanguard Dividend Appreciation picks stocks that have established a solid streak of increasing their dividends on a regular basis. The Nasdaq U.S. Dividend Achievers Select Index, which the ETF tracks, includes almost 200 stocks that have provided the requisite dividend growth. The fund is the largest on this list, with more than $27 billion invested in ETF shares. Returns have lagged its peers by a small amount, with annual returns averaging 11.6% over the past five years.

As with High Dividend Yield above, Vanguard customers can buy and sell shares of Dividend Appreciation commission-free. The fund's 2% yield is relatively small, though, and those who really need current income will probably prefer to look elsewhere for the higher yields the ETF's rivals currently offer.

Take a closer look at dividend ETFs

Regardless of which specific fund you select, dividend ETFs all share some valuable characteristics that can make them important contributors to the overall return of your portfolio. Whether you need ample dividend income right now, or you just want to benefit from the strong long-term performance that dividend stocks have produced over the years, dividend ETFs are a simple but effective way to get the investment exposure you want in order to reap the rewards of smart dividend stock investing.

Dan Caplinger owns shares of iShares Dow Jones Select Dividend and Vanguard Dividend Appreciation ETF. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.