How to Build an Income Portfolio with ETFs: Insights from David Fabian

David offers his insights below on how investors can utilize ETFs to build an income portfolio [see our List of ETF Friendly Advisors]:

ETF Database (ETFdb): What are the key components of a successful income portfolio?

David Fabian (DF): A successful income portfolio is made up of multiple asset classes that include: dividend paying equities, fixed-income, and alternative income strategies.

Most ETF income portfolios for retired or conservative investors are centered on core holdings in bonds because of the dependable dividends and reduced price swings. I tend to favor actively-managed funds such as the PIMCO Total Return ETF (BOND B) which carries a wide array of treasury, mortgage, and corporate debt of both developed and foreign nations. I like that active managers have the ability to control their sector allocations, duration, and credit profile to seek alpha. You can then subsequently overweight your fixed-income exposure in tactical sectors such as the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB A-) or iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD A) to enhance your returns [see also 101 High Yielding ETFs for Every Dividend Investor].

The dividend paying equity side of the portfolio is designed to provide market correlation along with inflation fighting effects over time. The Vanguard High Yield Dividend ETF (VYM A) is a favorite core holding that includes a broad array of nearly 400 stocks with strong dividend histories. One of the reasons I like this ETF is that it has an overweight allocation to technology stocks such as Apple Inc (AAPL), which has become a heavy weight in the dividend world and still offers excellent growth potential.

Lastly, the alternative sleeve of a successful ETF income portfolio provides exposure to REITs, MLPs, and preferred stocks. The Vanguard REIT ETF (VNQ A) and iShares U.S. Preferred Stock ETF (PFF A+) are two examples of alternative strategies that offer above-average yields and access to non-traditional asset classes. These are often overlooked by investors that are focused solely on common stocks and bonds.

ETFdb: Why does diversification play such a key role in this strategy?

DF: A diversified approach helps to minimize the risk of being overly concentrated in one asset class, increase the overall yield of the portfolio, and generally offers lower volatility.

By focusing exclusively on just one aspect of the income-generating world, you put all your eggs in one basket, which can lead to inconsistent returns. Conversely, spreading your money among a variety of sectors and strategies allows your portfolio to reap the benefits of non-correlated returns and steadier price action.

Alternative assets in particular are one area that can offer much higher yields and price trends that don’t directly correlate with stocks or interest rates. This provides a counterweight to your core equity and bond exposure, while still offering consistent income streams.

ETFdb: With so many income-oriented ETFs available, how do you decipher the best funds in each category?

DF: Dissecting the numerous ETFs available to income investors can be a tedious task. However, it is made much simpler with free tools from websites such as ETF Database to sort through the various options [see Complete List of Dividend-focused ETFs].

Below are some of the previously mentioned ETFs, and a few others as well, along with their respective yields (as of 2/25/2015):

The number one factor when selecting an ETF that will have the biggest impact on total return is the index construction methodology. This includes examining the underlying securities, sectors, and asset allocation to determine if they meet your overarching criteria. Each ETF will offer a unique opportunity based on its investment mandate.

I also encourage investors to pay close attention to fees – both underlying expenses and transaction fees at their broker. Many comparable ETFs offer widely varying fee structures, which can significantly impact your long-term performance. One example of this disparity is the 0.10% expense ratio charged by the Vanguard REIT ETF (VNQ A) and 0.45% expense ratio of the iShares U.S. Real Estate ETF (IYR A-). Both indexes offer comparable exposure to a diversified index of U.S.-listed REITs.

Volume and size are additional attributes to consider when analyzing comparable funds. Small funds or those with insignificant trading volume should be viewed with caution. I typically recommend that investors select 2 – 4 funds in each of the three categories to diversify their exposure [see also Dividend ETFs: 3 Things to Consider].

ETFdb: In the current environment, what is your advice for income investors who are looking to achieve above-average yield?

DF: The stretch for yield has been a theme on Wall Street over the last several years as the Federal Reserve has fought to keep interest rates low. However, many investors are still languishing in areas that are offering yields below 3%.

To combat the low yield environment, investors can get creative with their portfolio exposure and positioning. If they have a higher tolerance for risk, this may include greater allocations to the alternative asset sleeve of the portfolio or selecting bond holdings that include high yield and emerging market coverage.

The one word of caution I have is that, in general, high yield = high risk. Investors should assume that each incremental jump higher in income will come with a commensurate higher level of risk that includes price volatility. With the eventual tightening of interest rates on the horizon, this will become an important theme to manage moving forward.

ETFdb: How can active management play a role in an income portfolio?

DF: In my opinion, active management continues to be a significant driver of total return in the income investing world. This is particularly true when you have to factor in credit cycles, interest rate risk, and stock market returns. This will entail casting a wide net in the search for suitable investment opportunities with just the right mix of yield and risk to maintain purchasing power and an eye towards capital preservation [see also Monthly Dividend ETF Database Portfolio].

Sizing your allocations to each sleeve of the income portfolio is also an important consideration. An interest rate tightening cycle may call for lowering your allocation to bonds and increasing exposure to stocks, alternatives, or cash to capitalize on more advantageous prices in fixed-income down the road. Conversely, a volatile stock market may increase the need for quality fixed-income as a deflationary hedge.

The one commonality in this process is the use of low-cost, diversified, and liquid ETFs to generate sustainable income with consistent returns.

When it comes to generating a meaningful source of income, especially in the current environment, dividend-focused ETFs may offer creative solutions to yield-starved investors. With that being said, simply going after the highest-yielding securities is a surefire way to take on too much risk and leave your portfolio quite vulnerable. Consider the advice featured above and be sure to also do your own homework on any one fund before making an allocation; it’s always better to take your time and uncover any nuances before you’ve pulled the buy trigger.

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Disclosure: No positions at time of writing.