It is very popular with new investors. One of the most common ideas promoted on the Internet is the so-called “dividend snowball.” You buy dividend-paying stocks, collect the distribution, reinvest those dividends in more shares, get more dividends, and compound from there.
There is certainly some truth to the importance of reinvesting profits. According to update forum Testfolio, a $10,000 investment in the SPDR S&P 500 ETF Trust (SPY) made at the fund’s inception in 1993 would have been worth about $310,847 by mid-July 2026 in reinvested dividends. Without reinvesting the earnings, that same investment would have been worth about $175,008. That means an annualized return of 10.82% versus 8.85% without compounding dividends, or a cumulative return of 3,008.47% versus 1,605.08%.
But that doesn’t automatically mean that a dividend ETF is a superior investment. Many profitable ETFs have historically lagged the broader market, whether because they charge high management fees, don’t cover fast-growing sectors like technology, or focus less on growth stocks. Like any strategy based on a broad, market-weighted index, equity investments present viable bets that may outperform in some areas and underperform in others. That means that many investors conclude from this argument that dividend ETFs are either very good or poor investments.
I think both views miss the point. Dividend ETF can be a good investment. The reasons, however, are often different from those that are often promoted on financial social media and repeated by finfluencers. Understanding where dividend investing actually adds value can help investors make better decisions about which ETFs to include in their portfolios.
Why dividends are not free money
A dividend is simply a payment made by a company to its shareholders as a result of retained earnings. It is one of the ways in which management can return money to investors after the business has produced a profit. So, why would a company choose to do that instead of reinvesting?
In many cases, management simply does not believe it is a better use of cash. It may not see attractive opportunities to expand the business, acquire competitors, or buy back its shares at current valuations. Rather than allowing excess cash to accumulate on the balance sheet, it returns that cash to shareholders.
Some companies don’t have a choice. Certain US pass-through entities, such as real estate investment trusts (REITs), limited partnerships (MLPs), and business development companies (BDCs), are required to distribute a large portion of their taxable income.
In mature businesses, however, dividends often reflect the economics of the industry itself. Management evaluates all potential investments against the company’s estimated cost of capital, which represents the combined cost of financing the business with debt and equity. If management cannot identify projects that are expected to generate returns above that hurdle rate, holding money destroys value rather than creating it. Returning money to shareholders becomes a logical decision. This is one of the reasons why high dividend yields are often found in sunset stocks.
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Oil producers, for example, operate in a business of depleting resources where reserves must be replaced regularly, while tobacco companies are dealing with the long-term decline in smoking rates in many developed countries. These businesses can still generate a lot of cash, but they have fewer attractive opportunities for internal reinvestment. As a result, a large portion of the income is distributed.
A second misconception is that dividends somehow create wealth. They don’t. On the ex-dividend date, which is the first day a new buyer is no longer entitled to receive an upcoming dividend, the stock price typically falls by about the amount of the dividend, all else being equal. The share price may bounce back during the trading day as supply and demand fluctuate, but that is a different market event. Economically, money has left the company and is now on its way to shareholders. The same principle applies to dividend ETFs. On the day before the distribution, the net asset value of the ETF is reduced by the distribution amount because the assets have left the fund.
There is also an opportunity cost associated with focusing only on companies that pay dividends. Examining only dividend stocks quickly excludes the number of businesses that have created significant shareholder wealth without paying reasonable dividends. Berkshire Hathaway (BRK.B) has never been paid. Instead, longtime chairman and CEO Warren Buffett has built shareholder value by acquiring businesses, maintaining a strong balance sheet, and repurchasing shares when he believes they are trading below their true value.
Finally, there are taxes. Except for registered accounts, every dividend payment is generally a taxable event. Qualified Canadian dividends benefit from the dividend tax credit, making them more tax efficient than many other types of investment income. However, taxes still reduce the amount available for future reinvestment and consolidation. Holding dividend investments within registered accounts can remove or stop much of that tax burden, but in a non-registered account, all distributions must be reported and accounted for.
None of this is to say that the benefits are bad. It just means they should be viewed for what they are: one way to return money to shareholders, not a source of free cash or additional returns.
Why dividend investing still works
None of this is to say that dividend investing has not worked. On the contrary! Dividend investing has helped many investors build substantial wealth over the long term. But when I look at why dividend investing has been successful for so many people, I think there are two explanations.
The quantitative explanation is that many dividend ETFs provide anonymity to some of the same factors that academic research has linked to long-term returns. The biggest driver is still market beta, or equity ownership. But there are also other factors, including the size factor, which favors smaller companies, and the value factor, which favors companies that trade at less expensive valuations.
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Dividend ETFs often take indirect value exposure. Consider how the dividend yield is calculated. It is simply the annual profit (numerator) divided by the share price (denominator). If a company’s share price falls while its dividends remain the same, its yield rises. That doesn’t automatically make it a good stock pick, and relying on yield alone can lead investors into value traps. However, leveraged diversified ETFs that use systematic screening methods tend to reduce much of that company-specific risk, while capturing positive value exposure.
