It is particularly popular among newer investors. One of the most common ideas promoted online is the so-called “dividend snowball.” You buy dividend-paying stocks, collect the distributions, reinvest those dividends into additional shares, receive even more dividends, and compound from there.
There is certainly truth to the importance of reinvesting dividends. According to backtesting platform Testfolio, a $10,000 investment in the SPDR S&P 500 ETF Trust (SPY) made at the fund’s 1993 inception would have grown to approximately $310,847 by mid-July 2026 with dividends reinvested. Without reinvesting dividends, that same investment would have been worth about $175,008. That translates into an annualized return of 10.82% versus 8.85% without dividend compounding, or cumulative returns of 3,008.47% compared with 1,605.08%.
But that does not automatically mean dividend ETFs are superior investments. Many dividend ETFs have historically lagged the broader market, whether because they charge higher management fees, exclude faster-growing sectors such as technology, or place less emphasis on growth stocks. Like any strategy that departs from a broad, market-cap-weighted index, dividend investing introduces active bets that may outperform in some environments and underperform in others. That said, many investors conclude from this debate that dividend ETFs are either excellent investments or poor ones.
I think both views miss the point. Dividend ETFs can absolutely be good investments. The reasons, however, are often different from those commonly promoted on financial social media and repeated by finfluencers. Understanding where dividend investing actually adds value can help investors make much better decisions about whether these ETFs belong in their portfolios.
Why dividends are not free money
A dividend is simply a payment made by a company to its shareholders out of retained earnings. It is one way management can return capital to investors after the business has generated profits. So, why would a company choose to do that instead of reinvesting the money?
In many cases, management simply does not believe it has a better use for the cash. It may not see attractive opportunities to expand the business, acquire competitors, or buy back its own shares at current valuations. Rather than allowing excess cash to accumulate on the balance sheet, it distributes that capital back to shareholders.
Some companies have little choice. Certain U.S. pass-through entities, such as real estate investment trusts (REITs), master limited partnerships (MLPs), and business development companies (BDCs), are required to distribute a large portion of their taxable income.
For more mature businesses, however, dividends often reflect the economics of the industry itself. Management evaluates every potential investment against the company’s weighted average cost of capital, which represents the blended cost of financing the business through debt and equity. If management cannot identify projects expected to generate returns above that hurdle rate, retaining the cash destroys value rather than creating it. Returning the money to shareholders becomes the rational decision. That is one reason why higher dividend yields are often found in sunset industries.
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Oil producers, for example, operate in a depleting resource business where reserves must continually be replaced, while tobacco companies face long-term declines in smoking rates across many developed countries. These businesses can still generate substantial cash flow, but they have fewer attractive opportunities to reinvest it internally. As a result, a larger share of earnings is distributed.
The second misconception is that dividends somehow create wealth. They do not. On the ex-dividend date, which is the first day a new buyer is no longer entitled to receive the upcoming dividend, a stock’s price typically adjusts downward by approximately the amount of the dividend, all else being equal. The share price may recover later during the trading day as supply and demand fluctuate, but that is a separate market event. Economically, cash has left the company and is now on its way to shareholders. The same principle applies to dividend ETFs. On the ex-distribution date, the ETF’s net asset value is reduced by the amount of the distribution because assets have left the fund.
There are also opportunity costs associated with focusing exclusively on dividend-paying companies. Screening solely for dividend stocks immediately excludes a number of businesses that have created enormous shareholder wealth without ever paying meaningful dividends. Berkshire Hathaway (BRK.B) has famously never paid a dividend. Instead, chairman and longtime CEO Warren Buffett has compounded shareholder value by acquiring businesses, maintaining a fortress balance sheet, and repurchasing shares when he believed they traded below intrinsic value.
Finally, there are taxes. Outside registered accounts, every dividend payment is generally a taxable event. Canadian eligible dividends benefit from the dividend tax credit, making them relatively tax efficient compared with many other forms of investment income. Nevertheless, taxes still reduce the amount available for reinvestment and future compounding. Holding dividend investments inside registered accounts can eliminate or defer much of that tax burden, but in a non-registered account, every distribution must be reported and accounted for.
None of this means dividends are bad. It simply means they should be viewed for what they are: one method of returning capital to shareholders, not a source of free money or additional returns.
Why dividend investing still works
None of this is to say dividend investing has not worked. Quite the opposite! Dividend investing has helped many investors build substantial wealth over long periods of time. 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 inadvertently provide exposure to some of the same factors that academic research has linked to long-term returns. The biggest driver is still market beta, or simply owning equities. But there are other factors as well, including the size factor, which favours smaller companies, and the value factor, which favours companies trading at relatively inexpensive valuations.
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Dividend ETFs often pick up value exposure inadvertently. Think about how dividend yield is calculated. It is simply the annual dividend (numerator) divided by the share price (denominator). If a company’s share price declines while its dividend remains unchanged, its dividend yield rises. That does not automatically make it a good stock pick, and relying on yield alone can certainly lead investors into value traps. However, diversified dividend ETFs using systematic screening methodologies tend to reduce much of that company-specific risk, while capturing good value exposure.
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