ETFs may be used to produce a stream of income, and offer potential benefits of portfolio diversification.
Exchange-traded funds, or ETFs, can provide a potential income stream that generally offers more diversity than investing in just one stock. Whether you’re reorganizing your portfolio for your golden years, or just starting to build your nest egg, these investment options can be ones to consider.
Before investing in these funds, it’s helpful to learn a bit more about what they are, how they work, and their potential advantages and disadvantages.
An ETF is a diversified basket of securities designed to mirror the performance of a stock or bond portfolio. Essentially, an ETF attempts to spread out risk among multiple investments, but through the purchase of a single security. Like stocks, ETFs come in a variety of forms. Some ETFs, for example, aim to mirror the performance of a specific benchmark, such as a stock index. Some ETFs aim to produce income through investment in fixed-income securities or stocks that have historically paid dividends. Others target a specific sector such as retail or energy.
Unlike a mutual fund, which is priced and settled once a day to a net asset value (NAV), an ETF is listed on an exchange and can be bought or sold throughout the trading day, with prices fluctuating during each session, just like a stock. This may allow investors to get both the potential advantages of a diversified investment as well as a generally easier ability to buy and sell.
An ETF can help you diversify by distributing investments across sectors, subsets of sectors, and subclasses. Some ETFs might track:
ETF income comes from its components. Typically, that means dividends from stocks or interest yield from bonds.
Dividends: These are a portion of the company’s earnings paid out in cash or shares to stockholders on a per-share basis, sometimes to attract investors to buy the stock. Note that some funds choose to reinvest dividends rather than distribute them to investors. So, if you’re interested in receiving periodic payments, make sure you know whether a fund you’re considering distributes or reinvests dividends.
Companies that offer dividends are typically larger, more established businesses. And because the dividends are generally paid out of a company’s earnings or reserves, the payouts aren’t typically impacted by market fluctuations, so, you can generally expect a dividend on the designated payable date (assuming you owned shares of the ETF as of the ex-date) whether the market is up or down. Having a consistent stream of income makes it easier to stay on budget and plan for activities. But remember: Dividends are not guaranteed. Even companies that have historically paid dividends may choose, at their discretion, to decrease, or even stop issuing dividends.
Interest: Bonds can often deliver income in the form of their yield. A $10,000 investment in a government bond paying a 3% yield, for instance, would provide $300 in annual income. Remember that stocks and bonds are also valued by their underlying price, which can fluctuate both up and down. That’s something to consider, because you could potentially lose money in your underlying investment even while collecting interest income.
Here are some types of ETFs an income-seeking investor might want to consider:
You might consider complementing your portfolio with ETFs or creating an income-generating portfolio constructed only of ETFs. Either way, it’s important to consider taking a diversified approach so you’re not overly exposed in one asset class.
ETFs can be a low-cost way to pursue portfolio diversification, as they can avoid some of the transaction costs associated with individual stock-picking or the operating costs of actively managed mutual funds. But ETF newcomers such as actively managed ETFs and smart beta ETFs generally have higher expense ratios than passive ETFs, so you’ll want to research your choices and read each fund’s prospectus before investing.
The tax implications of ETFs can be complicated and vary depending on the asset class and structure, but in general, an ETF investment isn’t taxed until you sell it, so taxation of the ETF investment depends on how long you've held it. Any interest or dividend income you may receive while invested in an ETF, however, is taxable in the year you receive the payment, regardless of whether or not you're still invested in the ETF.
Fees vary across funds everywhere. Read the prospectus carefully, particularly if there are two or more ETFs tracking the same or similar indexes. You may find one ETF charges more in fees for the same investment versus another ETF with lower fees. Comparison shop for cost savings. And make sure the underlying securities of the ETF match what you’re looking for.
No investment is a sure thing, but a well-constructed portfolio, which might include ETFs, can help you create a steady stream of income for day-to-day expenses, travel and other discretionary items, or maybe to enhance your savings. ETFs are worth considering.
Carefully consider the investment objectives, risks, charges and expenses before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.
TD Ameritrade does not provide tax advice. Clients should consult with a tax advisor with regard to their specific tax circumstances.
Payment of stock dividends is not guaranteed and dividends may be discontinued. The underlying common stock is subject to market and business risks including insolvency.
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