Generating income with ETFs: A how-to guide

With nearly 10,000 baby boomers retiring every day, it is no surprise that income has become a quest for advisers and their clients. The demand isn’t going away anytime soon, a realization that many exchange-traded-fund providers have embraced. In fact, of the top 15 ETF providers in the U.S., every single one offers at least one product that is focused on providing current income.
There are over 500 ETFs that yield better than the 10-year U.S. Treasury.
Given the large universe of income-focused ETFs, there are many factors to consider when analyzing the choices. For instance, there are various categories of income, each with different returns, risks, and taxation. Here is a look at three groups: equity income, fixed income and alternatives.
EQUITY INCOME
Dividends have long been a crucial element of returns in the stock market. There are several ETFs that focus on dividend payers or growers that allocate across the globe. While equity yields have historically been lower than fixed income, the longer-term potential for capital appreciation is higher and, while these ETFs generally carry more volatility than bonds or alternatives, they can have less volatility than the overall stock market.
Keep an eye on the concentrations of sectors or countries inside ETFs in this category as they might hold a few surprises.
Generating income with equity ETFs will, of course, have tax consequences. Dividends (both qualified and ordinary) are passed through to ETF investors. Qualified dividends will be taxed at the lower dividend and capital gains tax rate (15% for most taxpayers) and ordinary dividends will be taxed as ordinary income. To be classified as a qualified dividend is a matter of time — both for the investor and the ETF’s holdings.
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The investor must own the shares 60 days prior to the ex-dividend date, and a further 60 days following (121-day window including the ex-date). On top of this, the ETF itself must own each underlying dividend-paying stock for the same 121-day window. ETF providers manage this within their funds and publish the percentage of dividends paid that were qualified at the end of the year.
Tax-sensitive investors looking for dividend income should investigate the rebalance frequency of the ETF; semi- or annual rebalancing will lower the chances of the ETF’s paying out dividends that are not qualified.
FIXED INCOME
There are over 250 U.S.-listed ETFs dedicated to fixed income, including short, intermediate, long, Treasury, corporate, municipal, emerging, inflation-linked, high-yield, floating-rate, and others. Given the breadth of available choices, the pros and cons of each type are beyond the scope of this discussion; however, keep this in mind: if something seems too good to be true, it probably is. Higher interest rates and/or credit risk demands a higher yield and vice versa. If one of those risks cannot be identified, then something is likely being overlooked.
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Fixed-income ETFs pay shareholders’ interest payments passed through from the ETFs underlying bonds and there are a few different ways these are taxed. Corporate bond interest is taxed as ordinary income; this may also include mortgage-backed and most agency bond interest. Outside of corporate bonds, both Treasury and municipal bonds enjoy some tax benefits. Interest on U.S. Treasury obligations and some federal agencies is taxed only at the federal level. The opposite is true for municipal bonds where interest is exempt from federal taxation. Finally, if an investor owns municipal bonds (or municipal bond ETFs) and lives in the state of issuance, interest is exempt from both federal and state taxes.
ALTERNATIVES
Preferred stocks, real estate investment trusts, master limited partnerships and some more esoteric vehicles that can fit into the ETF structure are extremely popular tools for generating income. These type of vehicles can be quite interest-rate-sensitive and can have other risks as well. Many preferred stocks are issued by banks and can be affected by bank earnings and regulatory changes. REITs are sensitive to changes in the real estate market, and MLPs can be affected by large swings in commodity prices.
To complicate things further, there is little consistency to how these income alternatives are taxed. Preferred stock dividends are generally qualified, while REIT dividends are usually not qualified and thus taxed at the ordinary income rate. MLP ETFs have complex tax treatments that range from qualified dividends to return of capital, depending on the amount of pure MLPs the ETF holds. Other potentially high-yielding alternatives may have unfavorable tax treatments, so it is important to keep those in mind before investing.
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Finally, there is another source of income that comes with almost all traded securities: capital appreciation. It is a very basic yet often forgotten method to support clients’ needs. In this age of zero rates, capital appreciation is as important as ever, and potentially more efficient as current U.S. tax policy allows for taking long-term gains at the same reduced tax rate as qualified dividends.
Many advisers and clients focus on only one of these aforementioned sources of income or fail to diversify within them. Combining them in a risk-managed asset allocation helps prevent concentration and can reduce overall interest rate sensitivity inherent to many income-oriented investments.
Grant Engelbart is a portfolio manager at CLS Investments.