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Income generation with ETFs: from growth to cash flow

This is episode 8 in our ETF investing series. ← Go to episode 7: 'The power of compounding: how ETFs help build wealth'

As investors approach retirement or seek to supplement their income, the focus often shifts from capital appreciation to generating reliable cash flow. ETFs offer several effective strategies for creating income streams without sacrificing the diversification and cost benefits that make them attractive investment vehicles.

Dividend ETFs: income from equity markets

Dividend ETFs focus on companies with a history of paying consistent or growing dividends, providing regular income while maintaining exposure to equity markets.

Types of dividend ETFs:

• High-yield dividend ETFs target companies offering above-average dividend yields, often in sectors like utilities, telecommunications, and consumer staples.
• Dividend growth ETFs focus on companies with a history of consistently increasing their dividends over time, typically indicating financial strength and sustainable payout ratios.

Real-world example:
A Saxo Bank client investing €100,000 in a European high-dividend ETF with a 4% yield could generate approximately €4,000 in annual income while maintaining potential for capital appreciation. Unlike individual dividend stocks, the ETF provides diversification across dozens or hundreds of dividend-paying companies.

Bond ETFs: fixed income building blocks

Bond ETFs hold portfolios of bonds, providing regular interest payments typically distributed monthly to investors.

Key bond ETF categories for income:

• Government bond ETFs offer lower yields but higher safety, making them suitable for conservative income investors.
• Corporate bond ETFs provide higher yields in exchange for taking on greater credit risk, with options ranging from investment-grade to high-yield (junk) bonds.
• Aggregate bond ETFs combine government and corporate bonds, offering a balanced approach to fixed income.

Real-world example:
A retiree seeking monthly income might invest in a corporate bond ETF that distributes interest payments each month. Unlike individual bonds, which typically pay interest semi-annually, these ETFs provide more frequent distributions by holding bonds with staggered payment schedules.

Real estate investment trust (REIT) ETFs: property income without property management

REIT ETFs invest in companies that own, operate, or finance income-producing real estate across various sectors like residential, commercial, healthcare, and data centers.

Income advantage:
REITs are required to distribute at least 90% of their taxable income to shareholders, resulting in typically higher yields than many other equity investments.

Real-world example:
An investor seeking exposure to real estate without the complexities of direct property ownership might invest in a REIT ETF yielding 3-5% annually. This provides regular income derived from property rents and leases across a diversified portfolio of real estate assets.

Preferred stock ETFs: hybrid income instruments

Preferred stock ETFs invest in preferred shares, which combine characteristics of both stocks and bonds, typically offering higher yields than common stocks or corporate bonds.

Income characteristics:
Preferred stocks pay fixed dividends that must be paid before common stock dividends, providing more reliable income than common stocks but with less potential for dividend growth.

Real-world example:
An income-focused investor might allocate a portion of their portfolio to a preferred stock ETF yielding 4-6%, creating a higher-yielding complement to traditional bond holdings.

Creating an income-focused ETF portfolio

For Saxo Bank clients transitioning from growth to income, consider this framework for building a diversified income portfolio:

• Core income (50-60%): Aggregate bond ETFs and dividend growth ETFs providing stable, reliable income with some inflation protection
• Yield enhancers (20-30%): Higher-yielding options like high-yield bond ETFs, REIT ETFs, and preferred stock ETFs to boost overall portfolio yield
• Growth component (10-20%): Broad market equity ETFs to maintain some growth potential and combat inflation over time

Practical considerations:

• Distribution frequency: Check whether ETFs pay monthly, quarterly, or annual distributions based on your cash flow needs
• Tax efficiency: Consider holding tax-inefficient income ETFs in tax-advantaged accounts where possible
• Total return perspective: Remember that yield is only one component of return; principal stability matters for sustainable income

By thoughtfully combining different types of income-generating ETFs, investors can create diversified portfolios that provide regular cash flow while maintaining the potential for some growth and inflation protection.

Next up: Advanced ETF strategies: leveraged, inverse, and synthetic ETFs