How To Build An ETF Portfolio For Income (2024)

What Are ETFs?

An exchange-traded fund is a pooled investment security that holds multiple underlying assets. ETFs differ from mutual funds in that shares of ETFs can be bought or sold on a stock exchange at any time during a trading day, while shares of mutual funds only trade once a day after the markets close.

ETF share prices fluctuate throughout a trading day and reflect that day’s trading activity. The price of a mutual fund share, known as the NAV (net asset value), is equal to the current net value of the fund's assets minus its current liabilities, divided by the number of outstanding shares. The NAV fluctuates daily as the value of the mutual fund’s underlying holdings changes, and as the number of outstanding shares changes. The NAV is calculated and published each day at 6:00 p.m. Eastern Time.

In the U.S. most ETFs are open-ended funds, which means that the fund can issue an unlimited number of shares. Among the various types of financial instruments, ETFs are the most tax-efficient because ETF share exchanges are considered as in-kind distributions, whereas stocks are taxed either at an investor’s normal income tax rate or at capital gains rates.

While you can only buy shares of a mutual fund through a broker, you can buy shares in ETFs through online investing platforms such as Fidelity Investments, investing apps such as Robinhood, retirement account providers or robo-advisors such as Betterment or Wealthfront. Many platforms offer screening tools that allow you to screen ETFs by their performance, trading volume, fund expenses and commissions charged.

How Do ETFs Work?

The first ETF was the SPDR S&P 500 ETF (SPY PY SPY ) that tracks the S&P 500 Index, which comprises 500 large-cap U.S. stocks. SPY first launched in January 1993, and between 2003 and 2022, the number of ETFs has grown from 276 to 8,754, with the value of ETF assets reaching almost $10 trillion by 2022.

ETFs can be categorized as being either actively or passively managed. Passively managed ETFs typically reflect the performance of an index, such as the S&P 500, or the performance of a sector, such as energy. Actively managed ETFs have portfolio managers who decide which assets and securities are included within the portfolio. Actively managed ETFs tend to be more expensive than passively managed funds.

An ETF can track the price of:

• Indexes
• Sectors
• Industries
• Commodities
• Securities
• Bonds

1. Industry/Sector ETFs focus on a particular industry or sector, such as consumer staples. They allow investors access to price increases within an industry, and by including more than one sector ETF within a portfolio, investors can smooth out any downsides. Many sophisticated investors typically rotate in and out of specific sectors depending on current macroeconomic conditions.

2. Stock ETFs hold a basket of stocks typically within a single industry or sector. This provides diversification because the funds typically hold a combination of high flying stocks along with new companies that might be poised for growth. Stock ETFs differ from stock mutual funds in that ETF investors do not actually own shares in the underlying securities and stock ETFs usually have lower fees than stock mutual funds.

3. Bond ETFs hold a basket of bonds that can include bonds issued by government Treasurys, corporate bonds, and state and local bonds also known as municipal bonds. The distributions made by bond ETFs are dependent on the performance of underlying bonds and unlike the bonds themselves, bond ETFs don’t have a maturity date.

4. Commodity ETFs hold commodities such as grains, crude oil, livestock or gold. Holding shares in a commodity ETF is much cheaper than holding the actual commodities themselves because investors don't have storage and insurance costs. Because commodities aren't closely correlated to equities, including a commodity ETF in an income ETF portfolio can help diversify that portfolio and serve as a hedge against equity downturns.

5. Currency ETFs track the performance of currency pairs, such as the U.S. dollar against the euro. Investors can use a currency ETF to speculate on currency prices based on the changing conditions within a country, and currency ETFs can be used by importers and exporters to hedge against volatility in forex (FX) markets.

6. Dividend ETFs own stocks in companies that have a history of paying dividends to their shareholders. It is these ETFs that are the best choices for income, and you can view our picks of the best dividend ETFs below.

7. Index ETFs track a benchmark index and the most well-known of them are:

• The SPDR S&P 500 (SPY), which tracks the S&P 500 Index and is the oldest ETF
• The iShares Russell 2000 (IWM IWM ), which tracks the Russell 2000 small-cap Index.
• The Invesco IVZ QQQ QQQ (QQQ), which tracks the Nasdaq 100 Index that contains technology stocks.
• The SPDR Dow Jones Industrial Average (DIA DIA ), which tracks the 30 stocks that comprise the Dow Jones Industrial Average.

With inflation running at 3.0%, dividend stocks offer one of the best ways to beat inflation and generate a dependable income stream. Download Five Dividend Stocks To Beat Inflation, a special report from Forbes’ dividend expert, John Dobosz.

How To Evaluate ETFs

When comparing ETFs, look for these metrics:

1. Dividend yield: A measure of an ETF’s income potential. It is calculated by dividing an ETF's total annual dividend payment by its share price. As with any investment, higher yielding ETFs can come with higher risk.

2. Expense ratio: Reflects how much you will have to pay for an ETF’s portfolio management, administration, marketing and distribution. High expense ratios eat into distributions. Passively managed funds usually have lower expense ratios than actively managed ones.

3. Liquidity is your ability to sell and buy shares in an ETF quickly and easily. It can be harder to sell shares in ETFs that have low total assets under management (AUM) or that have low daily trading volumes because there is less demand. This metric usually skews toward selecting ETFs that have higher AUMs.

4. Diversification: Problems can arise with ETFs whose holdings are highly concentrated in a single sector or in particular stocks or whose weightings favor a small handful of stocks. This means that funds having fewer portfolio constituents but greater diversification are preferable to funds having a greater number of constituents but less diversification.

How To Choose The Right ETFs For Income

Earlier this year, we provided you with lists of the best ETFs to buy for 2023, and the best dividend ETFs to outperform in 2023. Below is our list of eight high-dividend ETFs that provide investors access to a diversified portfolio of income-generating assets across multiple sectors and regions.

1. Vanguard High Yield Dividend ETF (VYM VYM ): With a dividend yield of 3.3%, this ETF tracks the FTSE High Dividend Yield Index, which holds more than 450 stocks that have above-average dividend yields. This fund has a low expense ratio of 0.06%.

2. Schwab U.S. Dividend Equity ETF (SCHD SCHD ): Having a dividend yield of 3.8%, this ETF tracks the Dow Jones U.S. Dividend 100 Index. SCHD contains high-yield stocks across multiple sectors that offer a high return on equity, and the fund screens for high free cash flow and a sustained dividend growth rate; its expense ratio is 0.06%.

3. SPDR S&P Dividend ETF (SDY SDY ): With a dividend yield of 2.7%, this ETF tracks the S&P High Yield Dividend Aristocrats Index, which is composed of stocks having a minimum of 20 consecutive years of dividend increases. SDY's portfolio contains multiple sectors, including such defensive sectors as industrials, utilities and consumer staples. SDY has a slightly higher expense ratio of 0.35%.

4. iShares Core High Dividend ETF (HDV HDV ): This fund has a dividend yield of 4.1%, and it tracks an index that is composed of 75 U.S. stocks within the energy and pharmaceutical sectors, such as ExxonMobil XOM (XOM) and Verizon Communications VZ (VZ). Each of these companies pays a high dividend and the fund’s expense ratio is 0.08%.

5. Vanguard Dividend Appreciation Index ETF (VIG VIG ): This fund has a dividend yield of 1.98% and tracks the Nasdaq US Dividend Growers Index, which is composed of more than 300 companies across multiple sectors, including technology, financial and healthcare. All these companies have a record of increased dividend growth, which indicates good capital management. VIG has an expense ratio of 0.06%.

6. Vanguard Real Estate ETF (VNQ VNQ ): With a dividend yield of 4.27%, this ETF tracks the MSCI US Investable Market Real Estate 25/50 Index, which is composed of approximately 175 companies that are invested in office buildings, hotels and other properties. VNQ has an expense ratio of 0.12%.

7. Invesco S&P 500 High Dividend Low Volatility ETF (SPHD SPHD ): This ETF has a high dividend yield of 4.40% and it tracks the S&P 500 Low Volatility High Dividend Index, which is composed of 51 dividend stocks that have low volatility but provide high dividend yields. The fund’s allocations are in the utility and consumer staples sectors, and its expense ratio of 0.30% is a bit higher than the other ETFs listed here.

8. Vanguard International High Dividend Yield ETF (VYMI VYMI ): This ETF has a dividend yield of 4.6% and it tracks the FTSE All-World ex U.S. High Dividend Yield Index. This fund allows investors access to high-yield dividend stocks from countries outside of the U.S., including Japan, U.K., Australia, Canada, China and Brazil. It has an expense ratio of 0.06%.

With inflation running at 3.0%, dividend stocks offer one of the best ways to beat inflation and generate a dependable income stream. Download Five Dividend Stocks To Beat Inflation, a special report from Forbes’ dividend expert, John Dobosz.

Why Are ETFs A Good Option For Income Investors?

ETFs offer a number of advantages for income investors. These include:

• By buying shares in an ETF, you are essentially buying shares in each of the assets contained within the ETF’s portfolio, and this can seriously save on broker commissions.
• ETFs have lower expense ratios than mutual funds, along with better tax benefits.
• ETFs can be bought and sold on exchanges throughout the trading day, while mutual funds can only trade once a day at the close of the markets. This gives investors greater control over their money.
• ETFs can be used to diversify an investment portfolio, thus helping to reduce risk.

ETF Portfolio For Income FAQs

What is the difference between an ETF and a mutual fund?

Investments in mutual funds are denominated in dollars, not market price or share price, while investments in ETFs are share based, and change hands at their current market price. ETFs generate fewer capital gains than mutual funds because many of them are passively managed and their creation/redemption mechanism minimizes any capital gains they distribute.

What are the risks of investing in ETFs?

The single biggest risk to EFTs is market risk because ETFs are composed of underlying assets whose prices can go up or down. If the price of its assets goes down, usually so will the price of the ETF.

How do I buy ETFs?

You can buy ETFs just like stocks through online investing platforms, investing apps, retirement account providers and robo-advisors.

With inflation running at 3.0%, dividend stocks offer one of the best ways to beat inflation and generate a dependable income stream. Download Five Dividend Stocks To Beat Inflation, a special report from Forbes’ dividend expert, John Dobosz.