There are several good reasons to add dividend stocks to your portfolio. Aside from the obvious reason of creating income, dividend stocks tend to hold up better than their non-dividend counterparts during tough times; they also tend to be less volatile in any market environment.

Having said that, owning individual dividend stocks isn't the right move for everyone. Simply put, many investors don't have the time, knowledge, or desire to research and construct a portfolio of solid dividend stocks. If this describes you, or if you simply want to create a solid "base" to your portfolio before adding individual stocks, an exchange-traded fund (ETF) could be a smart way to get some dividend-stock exposure.

Jar of coins labeled "dividends"

Image source: Getty Images.

What is an ETF?

An exchange-traded fund is similar to a mutual fund. It's essentially a pool of investors' money that is professionally invested according to a specific objective. For example, a large-cap growth stock ETF would invest its assets in stocks that fit that description.

In other words, like mutual funds, ETFs allow investors to spread their money around to many different stocks (or bonds or commodities), instead of choosing individual stocks.

Unlike mutual funds, ETFs trade directly on major stock exchanges and are bought and sold just like stocks. In other words, the price changes continuously during market hours based on supply and demand, and you choose a certain number of shares to buy instead of investing a specific dollar amount. Mutual-fund orders, in contrast, are generally priced and processed once per day after the market closes.

There are ETFs available for many different stock, bond, and commodity investment objectives. For example, if you want to invest in high-yield corporate bonds, gold, or small-cap value stocks, ETFs allow you to do it. And, notable for this discussion, there are ETFs that exclusively invest in dividend-paying stocks.

ETFs vs. individual dividend stocks

There are benefits and drawbacks both in ETF investing and in buying individual dividend stocks.

To be thorough, the term "dividend stock" in this context refers to any stock that makes a regular cash payment to shareholders. Dividend stocks can be smart choices for income-seeking investors, as they can generate steady income but have more long-term growth potential than other income-based investments like bonds. So why might you want to use ETFs to buy dividend stocks?

First, ETFs simplify the investment process. An ETF can allow you to buy a well-diversified portfolio of stocks with a single investment, and without the research and risk that comes with buying individual stocks.

A drawback of ETF investing is that you'll pay ongoing investment fees. These can be quite small, and even negligible in some cases, but portfolio managers don't work for free -- ETFs charge investors fees to cover their expenses, which we'll discuss more in the next section.

On the other hand, individual stocks have their own benefits. The main one is that individual stocks can potentially beat a stock index over time, while most ETFs are passive investments that track an index -- so a passive ETF will, by definition, match the performance of the index it tracks. Conversely, a portfolio of individual stocks can underperform a certain index over time, where an ETF guarantees you'll match the underlying index's performance after accounting for fees.

The costs of investing in ETFs

Since I mentioned fees a couple of times above, let's discuss the costs of ETF investing. There are two main costs to be aware of: ongoing investment fees and trading commissions.

The ongoing investment fees associated with ETF investing make up the expense ratio. This is available in the ETF's prospectus, on the ETF issuer's website, or in most comprehensive ETF quotes.

Expense ratios are expressed as a percentage of the ETF's assets and are paid out of the assets (you aren't billed directly). For example, an expense ratio of 0.3% means that for every $1,000 you have invested, you'll pay $3 in annual investment fees.

In addition, your broker may charge a trading commission, just as you would pay if you'd bought a stock. These can vary significantly depending on which brokerage you use. Some brokers actually have a commission-free ETF program, with a selection of ETFs that can be traded with no commission whatsoever, but the selection may be limited (and change often).

Additionally, you can usually buy ETFs without commissions directly from the ETF issuer. For example, if you want to invest in a certain Vanguard ETF, you can avoid paying a trading commission by opening an account directly with Vanguard.

Tax implications of ETFs

If you buy your ETFs using a tax-advantaged retirement account, such as an individual retirement account (IRA), you won't need to worry about tax implications on a regular basis. However, if you invest in a standard (taxable) brokerage account, there are some tax implications of ETF investing that you should know.

First are capital gains taxes, which are taxes on the profits from your ETF shares themselves. For example, if your ETF share price rises from $40 to $50, you have a $10 capital gain for every share you own.

However, capital gains aren't taxed until the shares are sold, at which point they are known as realized capital gains. Even if your ETF rises from $50 to $1,000 per share, if you haven't sold, it is still an unrealized gain and isn't taxable.

Once you sell at a profit, different capital gains tax rates apply depending on how long you owned the ETF shares. If you owned them for more than a year, you'll be taxed at long-term capital gains rates, which are lower than corresponding tax brackets for every income level. On the other hand, if you owned your ETF shares for a year or less, any realized gains will be taxed as ordinary income, according to your marginal tax bracket in the year you sell the shares.

The second tax issue you need to be aware of is dividend taxes. Unlike capital gains, ETF dividends are taxable in the year in which they're received. Most ETF dividends -- especially those paid by stock-focused ETFs -- meet the IRS definition of qualified dividends, which are taxed at the same favorable tax rates as long-term capital gains. There are some exceptions; I mentioned commodity ETFs already, and some international stock ETFs don't qualify for preferential dividend tax treatment.

The good news is your broker will keep track of which dividends should be classified in what manner, and will report the total to you (and to the IRS) on your year-end 1099-DIV tax form.

Active versus passive ETFs

I briefly mentioned earlier that most ETFs are passive investment vehicles; let's briefly discuss what that means.

There are two main types of ETFs and mutual funds; one is actively managed funds. The other is passively managed funds, also known as index funds.

Actively managed funds don't track a certain index. Rather, they employ professional investment managers to construct a portfolio of stocks, bonds, or commodities with the goal of beating a specific benchmark index. For example, a large-cap stock fund may compare its performance to the S&P 500 index. Because they employ active managers (who need to be paid), actively managed funds tend to have relatively high expense ratios.

On the other hand, passively managed index funds simply track an index with their investments. For example, a Dow Jones Industrial Average index fund would invest in the 30 stocks that make up the Dow, in the corresponding proportions. Since they don't require any type of complex investment strategy, index funds tend to have relatively low expense ratios.

Who should invest in a dividend ETF?

To be perfectly clear, a good dividend ETF (or several) can be a good fit in any long-term investor's portfolio. However, ETFs make particularly good sense for certain types of investors:

  • Risk-averse investors: Reliable dividends can help to create a "price floor" of sorts in stock prices, and bolster them during tough times. During market crashes, dividend stocks tend to significantly outperform their non-dividend counterparts.
  • Investors who want to put money to work in the stock market for long periods: If you want to invest for, say, five or more years, but don't want the task of choosing individual stocks, dividend ETFs are a good choice.
  • Older investors who rely on investments for income: If you're older and need income but want to maintain a significant stock allocation, dividend ETFs can be a good choice. I've written before that all investors, regardless of age, should be invested in an age-appropriate portfolio of stocks and bonds, and dividend ETFs can allow older investors to do this while still providing income.

If any of these categories describes you, a dividend ETF could be a smart choice.

Seven great examples of dividend ETFs

Now for the fun part. While there are plenty of excellent dividend ETF options in the market, there are a few that I regard more highly than others. And there are several varieties of dividend ETFs -- international versus domestic, for example.

With that in mind, here are seven of my favorite dividend ETFs, followed by a brief discussion of each:

ETF (Ticker Symbol)

Total Assets

Expense Ratio

Dividend Yield

Vanguard High Dividend Yield ETF (NYSEMKT:VYM)

$29 billion

0.08%

2.87%

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

$7 billion

0.07%

2.63%

SPDR S&P Dividend ETF (NYSEMKT:SDY)

$17 billion

0.35%

2.36%

SPDR Wells Fargo Preferred Stock ETF (NYSEMKT:PSK)

$663 million

0.45%

5.75%

Vanguard Dividend Appreciation ETF (NYSEMKT:VIG)

$36 billion

0.08%

1.82%

Vanguard International High Dividend Yield ETF (NASDAQ:VYMI)

$1 billion

0.32%

3.67%

Vanguard REIT Index Fund ETF (NYSEMKT:VNQ)

$60 billion

0.12%

3.56%

Data source: TD Ameritrade. All data obtained on Aug. 16, 2018.

Vanguard High Dividend Yield ETF

The Vanguard High Dividend Yield ETF tracks the FTSE High Dividend Yield Index, which consists of about 400 stocks that have above-average dividend yields, specifically excluding real estate investment trusts (REITs). Just to give you an idea, top holdings include JPMorgan Chase, ExxonMobil, Johnson & Johnson, and Wells Fargo.

With a low 0.08% expense ratio, investors get to keep most of the returns generated by the underlying stocks. And the returns can be substantial -- over the past decade, the ETF has produced annualized total returns of 10.2%. To put this into perspective, this means that if you had invested $10,000 in the ETF a decade ago, your investment would be worth more than $26,000 today.

Schwab U.S. Dividend Equity ETF

As far as dividend-specific ETFs go, the Schwab U.S. Dividend Equity ETF's 0.07% expense ratio is about the lowest you're going to find. This means for every $10,000 you have invested, your annual expenses are just $7.

Like the Vanguard fund I already discussed, the Schwab U.S. Dividend Equity ETF also invests in a portfolio of stocks with relatively high dividends, but it tracks a much narrower index. Specifically, the Dow Jones U.S. Dividend 100 Index contains, well, 100 stocks -- about one-fourth of the Vanguard fund. And while there's some overlap, many of the top holdings are different. In fact, of the top four stocks held by the Schwab U.S. Dividend Equity ETF -- PepsiCo, Procter & Gamble, Verizon, and ExxonMobil -- there is only one in common with Vanguard's.

The main consideration when deciding between these first two is that the Schwab U.S. Dividend Equity ETF has fewer stocks, which means that its larger holdings make up a greater percentage of its assets. Specifically, while the ETF's largest holding, PepsiCo, makes up 4.9% of the fund's assets, no stock in the Vanguard fund accounts for more than 3.6% of the total. In other words, the performance of the Schwab U.S. Dividend Equity ETF is more dependent on the performance of its top holdings than the Vanguard High Dividend Yield ETF is.

SPDR S&P Dividend ETF

You'll notice from the chart above that from an expense-ratio standpoint, the SPDR S&P Dividend ETF is significantly more expensive. However, it's important to note that a 0.35% expense ratio is by no means high -- the others are just unusually cheap.

Furthermore, the SPDR S&P Dividend ETF tracks a particularly desirable index -- the S&P High Yield Dividend Aristocrats. These are the stocks from the S&P Composite 1500 Index that have increased their dividend payments for 20 consecutive years or longer, and also pay above-average dividends. In other words, these stocks not only pay high dividends, but also have some of the most consistent track records of dividend growth over time.

The fund holds 111 stocks, none of which make up more than 2.2% of its assets. Top holdings include REITs Tanger Factory Outlet Centers, National Retail Properties, and Realty Income, as well as other high-yielding dividend growth stocks such as AT&T and ExxonMobil.

SPDR Wells Fargo Preferred Stock ETF

A preferred stock is a hybrid investment vehicle, with some characteristics of stocks and some of bonds. As with ordinary stocks, shares of preferred stocks trade on major exchanges, but like bonds, preferred stocks pay a fixed yield and typically don't have upside potential if the company does well. They are also senior to common shares in having a claim on the company's assets in situations such as bankruptcy, but they're subordinate to bondholders.

The reason I'm including the SPDR Wells Fargo Preferred Stock ETF here is that preferred stocks tend to pay excellent dividends. As of this writing, the ETF yields almost 5.3%. Remember, preferred stocks are designed for income and not for share-price appreciation, so this yield is likely to be the ETF's entire return. However, for investors who rely on their investments for income, a preferred stock ETF like this one could be a good fit.

Vanguard Dividend Appreciation ETF

The Vanguard Dividend Appreciation ETF tracks the Nasdaq U.S. Dividend Achievers Select Index, which contains companies with strong records of dividend increases over time. The index differs from the S&P High Yield Dividend Aristocrats in two main ways. First, the inclusion rules are not as specific. While the S&P index requires a 20-year consecutive streak of dividend increases, this ETF has no such requirement. For example, top holding Microsoft has increased its payout for 14 years in a row -- certainly impressive, but not enough to be included in the S&P High-Yield Dividend Aristocrats.

Second, this ETF's underlying index doesn't include REITs, while the S&P High-Yield Dividend Aristocrats index does, as mentioned earlier. Though REITs tend to pay high dividends, their stock prices are also highly sensitive to interest rates and don't always move with the overall market, so many investors prefer funds like this one that exclude them.

Vanguard International High Dividend Yield ETF

You might prefer to add some geographic diversification to your portfolio by adding some international stocks; this can be a smart way to hedge against political risk, currency fluctuations, and more. Plus, many international economies have pretty exciting growth potential, so an ETF specializing in international stocks can help you get exposure to these markets.

The Vanguard International High Dividend Yield ETF tracks an index of non-U.S. companies with high dividend yields. And many of these companies are household names to Americans, such as top holdings Nestle, HSBC, Royal Dutch Shell, and Toyota. With a dividend yield of nearly 5% as of this writing, the ETF pays significantly more than most U.S.-based dividend stock ETFs.

Vanguard REIT Index Fund ETF

I mentioned earlier that while REITs are technically stocks, they aren't very correlated with the rest of the stock market. Specifically, REIT stock prices tend to be highly sensitive to interest rates, which is the big reason they've underperformed the market over the past couple of years as rates have started to move higher.

Having said that, in addition to paying high dividends, REITs also have excellent long-term growth potential as their underlying property values increase, so it may be a smart idea to consider a REIT-specific ETF such as the Vanguard REIT Index Fund ETF. Top holdings include American Tower (invests in cell towers), Simon Property Group (shopping malls), Crown Castle International (also cell towers), Public Storage (self-storage properties), and Prologis (distribution centers and warehouses).

The risks of investing in dividend ETFs

A final thought: No stock investment is without risk.

To be sure, investing in dividend stocks through ETFs helps to mitigate the company- and sector-specific risks (also known as unsystematic risks) of stock investing. For example, if you own a broad dividend ETF and one company posts a bad quarterly report, the effect on your investment is likely to be minimal.

On the other hand, you'll still need to worry about risks that don't have to do with diversification (systematic risks). For example, if the entire stock market crashes, as it did in 2008-2009, your dividend ETFs are likely to decline in value.

Another big risk has to do with interest rates. If interest rates rise, it tends to put pressure on all income-generating investments, including dividend stocks.

To sum it up: Investing in dividend ETFs does have risks, especially over shorter time periods. However, it's still an excellent way to generate a growing income stream and, over long periods of time, fantastic returns.

Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Matthew Frankel owns shares of AT&T, Public Storage, Realty Income, and Tanger Factory Outlet Centers. The Motley Fool owns shares of and recommends American Tower. The Motley Fool owns shares of Johnson & Johnson and has the following options: short October 2018 $135 calls on American Tower and long January 2019 $80 calls on American Tower. The Motley Fool recommends Crown Castle International and HSBC Holdings. The Motley Fool has a disclosure policy.