Understanding ETFs and their dividends

Exchange-traded funds (ETFs) have become a popular investment option for many investors. It is evident by the doubling of the number of ETFs in a short span of three years, from 84 to 171 (March 2020 to March 2023).

However, the unique structure of ETFs and their dividend plans can sometimes be confusing.

In this article, we will attempt to explore how ETF shares are created, how dividends work within ETFs, and the tax implications of investing in them.

What are ETFs?
Exchange-traded funds (ETFs) are securities that track an index, like the Nifty 50, and deliver performance in line with that index.

They trade on stock exchanges like shares of a company.

They are similar in terms of performance to index funds, but different in the way shares are created.

How are ETFs created?
ETF shares are created by the AMC (asset management company) upon request from authorised participants (AP), usually market makers or large institutional investors. The AP purchases the underlying securities, known as the creation basket, that the ETF needs to hold.

The AP then delivers the securities to the fund house or asset management company, receiving a block of ETF shares in return.

For instance, if an ETF tracks the Nifty, the AP buys all 50 stocks in the index (creation basket) and delivers them to the AMC. In return, the AP gets ETF shares of equivalent value.

These shares, which are usually created in large lots, can then be traded on stock exchanges. The AMC will specify the basket of securities for creation/redemption on a daily basis.

ETF returns and taxes
Like mutual funds, ETFs have growth and dividend plans.

Which is better
We often get asked whether one should invest in an ETF that gives dividends or opt for one that doesn't (a growth plan).

Our advice is pretty straightforward: Choosing an ETF that gives dividends is not worth it.

Because the dividend paid is simply a part of the capital you had originally invested. This not only reduces the net asset value (NAV) but also the price of the ETF.

In addition, you lose out on the benefit of compounding from staying invested.

Last but not least, the dividends you receive are not tax efficient, and can be taxed up to 30 per cent

Therefore, opting for a growth plan is a smarter choice than a dividend plan.

Suggested read: The one thing you must know before investing in ETFs

This article was originally published on May 16, 2023.