In one of the all-time best action thrillers, archeologist and adventurer Indiana Jones survives snake pits and highway bandits to win the prize, only to see it mothballed in a government warehouse. Many investors end up like Jones, taking plenty of risks without any big reward in return. By contrast, dividend investing is not known for its excitement, but its steady approach can smooth the risks and provide steady income.

Today, three key developments are driving interest in dividend investing: recent tax law changes, uncertain equity returns and a titanic demographic shift away from growth to income investing. Realizing the opportunity at hand, companies like Mergent and Dow Jones have developed dividend indices, each with its own rigorous methodology. “Dividend investing works for young and old investors alike as dividend paying companies typically generate higher total returns with less volatility,” says Shirley J. Petersen, vice president of index services at Mergent.

As investor demand for dividend-oriented financial products has risen, so has supply. Launched in the fall of 2003, the iShares Dow Jones Select Dividend Index Fund (DVY) set the tone; as a result of its head start, the fund has become one of the largest ETFs out there, with roughly $6 billion in assets. The fund tracks 114 holdings weighted according to dividend payout. Top sectors include bank stocks (over 35 percent of assets) and electricity companies (13.84 percent).

PowerShares has four dividend-oriented ETFs, all based on Mergent indices. The PowerShares Dividend Achievers (PFM), the broadest of the group, held 318 stocks during the first quarter. For those interested in high income, the PowerShares High Yield Equity (PEY) targets an index of 50 high-yielding companies with a track record of raising dividends for at least the last 10 years. At the end of May, PEY had a yield of 3.24 percent. On the global front, the PowerShares International Dividend Achievers (PID) tracks American Depository Receipts (ADRs) with a five-year track record of dividend hikes, most recently holding 60 stocks with a collective yield of 2.89 percent.

The First Trust Morningstar Dividend Leaders Index (FDL) screens stocks with five-year dividend growth and weights them in proportion to their “available” dividends, which Morningstar calculates by multiplying the dividend per share by the float. Individual stock weightings are capped at 10 percent and stocks weighing more than 5 percent cannot exceed 50 percent of the portfolio.

State Street’s SPDR Dividend (SDY) tracks the Standard & Poor’s High Yield Dividend Aristocrats index of the 50 highest-yielding stocks in the S&P 1500 with 25 years of rising dividends behind them. At the end of May, it had a yield of 2.54 percent and a low 30 basis-point expense ratio.

Not to be outdone, Vanguard launched the Dividend Appreciation VIPERs (VIG) in April. The fund uses the Mergent Dividend Achievers Select index, a subset of Mergent’s broadest dividend benchmark. It has 215 holdings with consumer staples, financials and industrials accounting for 60 percent of the sector weighting.

Newcomer WisdomTree Investments is also banking on dividend investing. In June, the company introduced a suite of 20 dividend-focused ETFs representing high-yield stocks from the Pacific Rim and Europe as well as domestic equities.

Tax Law

The Jobs and Growth Tax Relief Reconciliation Act of 2003 changed the way the IRS treats dividends. Previously, dividend income was taxed as ordinary income at the taxpayer’s highest marginal rate. Now, investors with qualifying dividend income in tax brackets above 15 percent are taxed at a maximum rate of 15 percent — or 5 percent for lower tax brackets. The 5 percent tax on dividends will be reduced to zero in 2008, while the 15 percent tax will remain unchanged. Unless Congress acts to extend it, the Tax Relief Act is set to expire in 2009.

It’s important to remember that not all dividends are “qualified” or entitled to the more beneficial tax treatment. As such, qualified dividend income (QDI) is an important aspect of dividend investing with ETFs. QDI only applies to dividends received directly from U.S. stocks and qualified foreign companies. For ETFs, income generated from bonds, money markets and other fixed-income instruments is not considered QDI, regardless of whether the income is obtained directly or indirectly. Furthermore, dividends from ETFs that invest in real estate investment trusts (REITs) generally do not qualify.

To get the full reward of QDI, both the fund and the shareholder must satisfy a 61-day holding period. For the investor, this excludes the date of purchase but includes the ex-dividend date. At the fund level, an ETF must meet the same holding period requirements of the underlying stocks.

When it comes to QDI, some ETFs were created more tax efficient than others. As John Woerth, a spokesperson for the Vanguard Group points out, “dividend distributions for Vanguard Value Index Fund (VTV) were 100 percent qualified for the past three years, whereas the percentage of qualified income produced by two comparable ETFs was much lower.” Woerth urges financial advisors to pay careful attention to both fund income and capital gains distributions.

Since QDI is only one factor in the spectrum of ETF decisions, some industry insiders warn about overemphasizing its impact, citing other factors such as total return, expenses and tracking error as important considerations. Naturally, QDI is not part of the equation at all for ETFs held in retirement accounts like traditional or Roth IRAs. The ultimate impact of QDI at the shareholder level is dependent on income tax brackets. Since investors in higher brackets have more at stake, QDI is likely a more important consideration for them.

Still, QDI does play a significant role. According to an April report from Lipper, even though equity fund investors experienced a 138 percent rise of income distributions since 2002, their actual tax bills rose by a paltry 30 percent. Senior Research Analyst Tom Roseen, the report’s author, notes that “the majority of these distributions were taxed at the lower QDI rate of 15 percent. Historically, the tax rate on equity dividend income was the highest marginal rate.”

The Future Of Dividends

More investors will rely upon dividends as they shift from growth to an income and capital preservation strategy. While pure growth usually gets all the attention, it’s actually dividends that may end up accounting for a larger portion of an investor’s future returns.

Dividends could be the big financial payoff at the end of Indiana Jones’ adventure.

RON L. DELEGGE is editor of www.etfguide.com.