5 Best ETFs to Help You Earn Passive Investment Income
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The world of passive income is fertile ground for grifters, scammers and charlatans. The sales pitch practically writes itself: Sit back, do nothing and collect a paycheck.
Before you buy into one of these schemes, consider whether and to what extent the promoter makes their own passive income by selling courses, subscriptions and/or coaching programs.
For U.S. investors, one of the simplest ways to earn genuine passive income is to own cash-generating securities inside a brokerage account. With a big enough portfolio, you can fund some or even all of your living expenses.
Those cash flows can come from dividend stocks, bonds that bear interest or, increasingly, distributions from exchange-traded funds (ETFs).
The assets and strategies behind these ETFs can vary considerably. Some, such as dividend ETFs, own dividend-paying stocks. Some, such as bond ETFs, just hold bonds. Others use derivatives such as covered calls to generate additional cash flow.
Their common objective is to produce regular income above what you might receive from a comparable stock or bond benchmark, and many pay distributions every month.
There’s an important catch: Income is not free. On an ETF’s ex-distribution date, its net asset value (NAV) generally falls by approximately the amount of the upcoming distribution, all else being equal.
That money has left the fund and is being transferred to you. And you could create a similar cash flow by periodically selling shares of a non-income-focused ETF.
If you have a long time horizon, you may be better served reinvesting distributions or prioritizing ETFs with stronger capital-appreciation potential and allowing your portfolio to compound.
High distributions can be useful. But a double-digit yield doesn’t automatically translate into a superior investment. Total return remains the yardstick for evaluating an investment’s performance.
For retirees drawing down their portfolios or members of the “financial independence, retire early” (FIRE) movement who want recurring cash flow, however, income-focused ETFs can be useful tools.
The challenge is separating sustainable income strategies from funds that simply advertise the biggest headline yield. Here are five ETFs that approach passive investment income in different ways.
What to look for in a passive income ETF
The most obvious place to start when evaluating a passive income ETF is yield. But that number requires context.
How much yield you actually need depends on the size of your portfolio and anticipated withdrawals.
Someone withdrawing $40,000 annually from a $1 million portfolio has different yield requirements from someone trying to generate the same income from $500,000.
Yields can also fluctuate. Bond yields respond to interest rates and credit conditions, while stock dividends can be increased, maintained or cut depending on corporate profitability and management decisions.
Today’s distribution rate should not be treated as a guaranteed future payout.
Distribution frequency matters as well. Most conventional ETFs make quarterly distributions, whereas monthly dividend ETFs are designed specifically for income investors.
A smaller subset now distributes weekly, although these remain the exception. For investors matching portfolio income against recurring living expenses, monthly distributions can make cash-flow management easier.
It’s also worth understanding an ETF’s distribution calendar. The ex-distribution date determines which shareholders are entitled to the upcoming payment, while the payment date determines when that cash actually arrives.
ETF providers generally publish these schedules in advance, although the precise distribution amount may not be announced until closer to the date.
Then there’s tax efficiency. This matters less inside a Roth IRA, where qualified withdrawals of earnings are tax-free once the account has satisfied the five-year rule and the investor is at least age 59 and a half, among other qualifying circumstances.
In a taxable brokerage account, however, distributions can create tax liabilities as they are received. And not every distribution receives the same treatment.
Depending on the ETF’s holdings and strategy, income could consist of ordinary income; qualified dividends; short and/or long-term capital gains; federal and/or state tax-exempt interest; or return of capital.
As we’ll see with some of the ETFs below, certain strategies can defer some taxation or qualify for more favorable rates. That makes after-tax yield at least as important as the headline distribution rate.
Above all, keep total return in perspective. Before buying an income ETF, ask whether you actually need the cash today.
If every monthly distribution is immediately reinvested, specifically targeting a high yield may accomplish little while potentially introducing higher fees and additional taxes
Investors who can get past the psychological distinction between “income” and selling shares have even more flexibility. An ETF distribution reduces the fund’s NAV because cash is leaving the portfolio and going to shareholders.
Selling a small number of shares yourself can produce a similar economic result while giving you control over the timing and amount of the withdrawal.
How we screened for the best passive income ETFs
There is no single best passive income ETF because no two income investors necessarily have the same portfolio size, required yield, tax situation, risk tolerance and time horizon.
So our goal was to select five different ETFs that investors can mix and match based on their priorities, while highlighting what each one does well and where its weaknesses lie.
Despite the differences in their underlying strategies, we were still able to establish some common screening criteria.
First, we required each ETF to be well-capitalized, rather than a niche product potentially vulnerable to closure from insufficient investor interest.
A minimum of $500 million in assets under management (AUM) is high enough to capture established funds with meaningful investor adoption while leaving room for newer strategies that have quickly attracted assets.
We also established a minimum 3% 30-day SEC yield where that metric is applicable to provide a meaningful level of income relative to broad equity benchmarks.
These yields represent a snapshot in time rather than a guaranteed payout. They can fluctuate as portfolio income changes and, depending on the yield calculation, as the ETF’s net asset value moves.
Finally, we placed a high priority on fees. Expense ratios directly reduce both the income investors ultimately receive and their long-term total returns.
Income ETFs can be more expensive than conventional index funds because some employ active management or derivatives, so we allowed somewhat more room here.
Even so, we capped the expense ratio at 0.35%. For every $10,000 invested, that translates into no more than approximately $35 in annual fund expenses, all else being equal.
The low-risk income option: Invesco Short Term Treasury ETF
Many of you looking for passive income are retirees. This demographic generally has a shorter investment time horizon. That means there are fewer years available before invested assets need to fund living expenses. It typically means a lower tolerance for large portfolio fluctuations, too.
An equity income ETF may offer greater long-term return potential, but its volatility may be inappropriate for the portion of a portfolio earmarked for near-term spending.
A short-term Treasury ETF such as the Invesco Short Term Treasury ETF (TBLL) provides a much more conservative alternative. TBLL tracks a portfolio of U.S. Treasury bills with remaining maturities of no more than 12 months.
These securities carry the credit backing of the U.S. government, while their extremely short maturities result in very little sensitivity to interest rates. So you should generally expect considerably smaller price fluctuations than you’d experience with stock and bond funds.
The trade-off is limited total-return potential. TBLL essentially provides exposure to something close to the prevailing risk-free rate of return. With little credit or duration risk taken, there’s little opportunity to earn a substantial return premium.
After accounting for its 0.08% expense ratio, TBLL offers a 3.7% 30-day SEC yield. You can generally expect this ETF’s yield to move in the vicinity of prevailing short-term interest rates.
Because TBLL’s portfolio consists of U.S. Treasury securities, qualifying Treasury interest distributed by this ETF is generally exempt from state and local income taxes.
That can make TBLL’s after-tax yield particularly attractive for those of you who are residents of states with high income tax rates.
Learn more about TBLL at the Invesco provider site.
The tax-efficient option: State Street SPDR Nuveen ICE High Yield Municipal Bond ETF
State income taxes are only part of the equation when you evaluate the after-tax value of passive income. Their impact can be particularly noticeable if you live in a high-tax state such as California or New York. But investors nationwide also need to contend with federal income taxes.
If you want to shelter more of your portfolio income from federal taxes, the State Street SPDR Nuveen ICE High Yield Municipal Bond ETF (HYMB) offers one potential solution. HYMB invests in municipal bonds, debt securities issued by state and local governments and their agencies.
Where HYMB differs from a conventional municipal bond ETF is its ability to allocate to non-investment-grade debt. These lower-rated bonds carry greater credit risk, which means there’s a higher probability an issuer has trouble making interest payments or returning principal.
Investors are compensated for taking additional credit risk with a higher level of income. HYMB currently offers a 4.9% 30-day SEC yield, which is already above what investors can earn from many investment-grade bond ETFs.
That headline yield figure can also understate the true value of the income for investors in higher tax brackets. Municipal bond interest is generally exempt from federal income tax, subject to the tax characteristics of the individual securities and investor.
Based on the highest marginal federal income tax rate, State Street calculates an 8.2% tax-equivalent yield for HYMB.
In other words, a taxable bond investment would need to yield approximately 8.2% to provide the same after-tax income under that assumption.
Learn more about HYMB at the State Street Investment Management provider site.
The higher-yield bond option: Schwab High Yield Bond ETF
With bonds, you’ll see a basic relationship between credit quality and yield. Investment-grade corporate bonds yield more than Treasury bonds of comparable maturities because investors need to be compensated for taking additional credit risk.
Move below BBB and you enter the world of non-investment-grade bonds. High-yield bonds carry substantially greater risk; that’s why they’re often referred to as junk bonds.
Historical default statistics help put that additional risk into perspective. According to S&P Global, BBB-rated issuers have historically experienced a three-year cumulative default rate of just 0.9%.
Move down one notch into high yield at BB and that rises to 4.2%. For B-rated issuers, it increases again to 12.4%, while CCC/CC-rated issuers have historically experienced substantially higher default rates of 45.7%.
Holding these securities through a diversified ETF can help mitigate the company-specific consequences of individual defaults. The Schwab High Yield Bond ETF (SCYB) provides a good example.
SCYB tracks a broad benchmark containing more than 1,800 high-yield bonds, spreading the ETF’s exposure across numerous issuers. Investors are still taking meaningful risk. Just under 60% of SCYB’s portfolio is rated BB, approximately 30% is rated B and roughly 8% sits in the CCC category.
During recessions or periods of severe credit-market stress, defaults can increase and high-yield bond prices can decline as investors demand greater compensation for bearing that risk. The income potential is correspondingly higher.
SCYB currently offers a 7.0% 30-day SEC yield, making it one of the higher-yielding conventional bond options available to passive income investors. SCYB also charges a rock-bottom 0.03% expense ratio, or just $3 annually for every $10,000 invested.
Taxation is the main drawback for this ETF. Interest from corporate bonds is generally taxable as ordinary income at the federal level and may also be subject to state income taxes.
That can make holding SCYB inside a tax-advantaged account such as a Roth IRA particularly attractive whenever possible.
Learn more about SCYB at the Schwab provider site.
The qualified dividend option: iShares Core High Dividend ETF
For passive income investors using a taxable brokerage account, qualified dividend income can be considerably more attractive than ordinary income. Qualified dividends are generally taxed at the preferential long-term capital gains rates rather than at ordinary federal income tax rates.
Funds focused on U.S. dividend-paying corporations are generally better positioned to generate qualified dividend income, provided applicable IRS requirements are satisfied.
One important exception is real estate investment trusts (REITs). REIT distributions generally do not qualify for preferential qualified-dividend treatment, although eligible investors may qualify for the 20% Section 199A deduction.
One suitable equity option is the iShares Core High Dividend ETF (HDV), which recently converted from quarterly to monthly distributions.
HDV tracks the Morningstar Dividend Yield Focus Index, which selects 75 dividend-paying U.S. stocks after applying several fundamental screens. From there, qualifying stocks are weighted primarily according to their 12-month dividend yields, subject to the index’s portfolio construction rules.
The screens include Morningstar’s “Economic Moat” rating, which assesses whether a company possesses a sustainable competitive advantage; its “Uncertainty” rating, which reflects the range of potential outcomes surrounding Morningstar’s fair value estimate; and a “Distance to Default” score incorporating factors such as operating leverage and earnings volatility to assess financial health.
After accounting for its low 0.08% expense ratio, HDV currently pays a 3.4% 30-day SEC yield. Historically, a high percentage of its distributions have qualified for preferential qualified-dividend tax treatment, although investors will not know the precise tax characterization of the current year’s distributions until the fund reports it after year-end.
Unlike a bond fund, HDV also offers meaningful potential for capital appreciation alongside its income. With distributions reinvested, the ETF has generated a 9.1% annualized total return over the trailing 10 years before taxes. However, this was accompanied by more risk than the average bond ETF.
Learn more about HDV at the iShares provider site.
The tax-deferred option: JPMorgan Equity Premium Yield ETF
Many income ETFs attempt to boost their distributions by selling options. The most familiar strategy is the covered call. In simple terms, the fund collects an upfront option premium in exchange for giving up some of its potential upside if the underlying asset rises beyond a specified price.
The JPMorgan Equity Premium Yield ETF (ROCY) modifies this approach. ROCY owns an actively managed portfolio of U.S. large-cap stocks while selling S&P 500 call spreads to generate additional cash flow.
A call spread involves simultaneously selling one call option while buying another call with a higher strike price, allowing the strategy to potentially capture more upside versus traditional covered call ETFs.
ROCY’s use of options also allows a significant portion of its monthly distributions to potentially be classified as return of capital (ROC).
Broadly, ROC represents distributions exceeding the fund’s net investment income and realized gains for tax purposes, rather than dividend or interest income. For passive income investors using a taxable account, ROC can provide a useful form of tax deferral.
A return-of-capital distribution generally is not immediately taxable. Instead, it reduces the investor’s adjusted cost basis in the ETF. When you eventually sell, the lower cost basis means a larger taxable capital gain, so the tax liability has generally been postponed rather than eliminated.
For example, ROCY’s June 1 distribution was approximately 39 cents per share. share. According to the ETF’s Section 19a notice (PDF), 7.4% was estimated to come from net investment income, while the remaining 92.6% represented distributions in excess of net investment income.
However, those figures are estimates rather than the final tax characterization. An investor must rely on their Form 1099-DIV to determine how much, if any, of ROCY’s distributions were officially classified as ROC.
Learn more about ROCY at the JPMorgan Asset Management provider site.