I recently wrote on how to build an income portfolio through the share market. This follow-up article aims to address questions I received from readers on how to apply this strategy to ETFs.

Below I explain how I use ETFs in my own income investing strategy, but first, let’s explore the ways it works—and the potential pitfalls.

Using ETFs to build an income portfolio

The simple answer is yes, ETFs can be used to build an income portfolio, but there are some caveats.

A dividend reinvestment plan (DRIP) can be used for ETFs in the same manner they are used for individual shares.

Do ETFs pay dividends?

ETFs do not technically pay dividends and instead provide investors with distributions. The difference in terminology has implications.

Distributions and dividends—what’s the difference?

A distribution includes any dividends generated by the underlying shares held in an equity ETF. It also includes any capital gains generated from selling appreciated assets held in the ETF.

There are several scenarios where capital gains can be generated in an ETF.

In an active ETF where a portfolio manager is responsible for making buy and sell decisions it can happen based on those decisions.

In a traditional passive ETF that follows a broad index it can happen when there are index changes.

For example, if an ETF follows the ASX 200 it will invest in the 200 largest companies in Australia as measured by market capitalisation. If the 201st largest company becomes more valuable than the 200th the index will change and the ETF will follow suit.

These changes do occur, but the impact is generally muted because these broad indexes are market capitalisation weighted. That means the smallest positions are the ones that are often moving into and out of the index.

Yields: The fine print

The place that investors can run into trouble is with ETFs that don’t track broad based indexes.

These include thematic ETFs and factor ETFs. These ETFs likely change holdings more frequently and are more likely to have rebalancing. These changes can trigger capital gains in rising markets.

The Global X FANG+ ETF (ASX: FANG) is the perfect example. The ETF follows the NYSE FANG+ Index but that doesn’t mean it is a true passive product in the traditional sense. The ‘index’ includes only 10 securities picked by a committee which are “highly-traded growth stocks of next generation technology and tech-enabled companies.” Whatever that means.

The index is rebalanced quarterly so that it maintains equal weighting between the 10 constituents. Rebalancing involves the selling of positions that have relatively outperformed to buy more of the positions that underperformed. In rising markets this will generate capital gains. Since this occurs quarterly it has the potential to generate a lot of capital gains.

We can see this impact on FANG distributions. In July 2020 it paid a distribution of $0.1194, in 2021 it paid a distribution of $2.17 and in 2022 the distribution was $0.6864.

Yet the majority of this distribution was capital gains. Only 3 of the 10 holdings pay a dividend.

One of those holdings is NVIDIA (NAS: NVDA) and the dividend is negligible with a yield of 0.07%. But that doesn’t stop websites from quoting a yield of 5.60% on the ETF. The dividend yield on the underlying holdings of the ETF is 0.17%.

Why it matters

Some investors may argue that this doesn’t matter. A distribution is after all cash that is deposited in your account and the tax treatment in Australia between dividends and capital gains is the same.

But this view misses the point for many income investors.

Many investors use an income investing strategy because they want—or need—to spend the cash generated by their portfolio.

Since the capital gains component can swing wildly based on market performance using certain types of ETFs in your income portfolio is problematic. This is the equivalent of trying to budget while having your pay check swing wildly month to month.

The FANG ETF is an extreme example given the minimal number of holdings and quarterly rebalancing but there are more mainstream ETFs which Morningstar rates highly which can also exhibit the same tendencies.

For instance, the VanEck Australian Equal Weight ETF (ASX: MVW) receives a Silver rating from our analysts and is a solid option for investors that are looking to avoid the overweighting of banks and miners in the market capitalisation weighted ASX tracking products.

To maintain an equal weighting it too is rebalanced quarterly which can distort distributions with capital gains.

The dangers of chasing ETF yields

This risk was illustrated in a recent social media post by a popular market commentator. The post promised the “5 best dividend paying ETFs of 2022.”

It included the BetaShares Australian Resources Sector ETF (ASX: QRE), SPDR S&P/ASX 200 Resources ETF (ASX: OZR), SPDR Australian Select High Dividend Yield ETF (ASX: SYI), SPDR World ex-Australia Carbon Control ETF (ASX: WXHG) and BetaShares Crude Oil Index ETF (ASX: OOO).

The post included the ‘yields’ on each of the ETFs based on the 2022 distribution.

I won’t go through each of the names on this mostly dubious list, but the BetaShares Crude Oil Index ETF was the highest yielding of the names and, in my opinion, the most ridiculous ETF to include.

The yield was quoted as 45%.

Before moving all your money into the ETF and turning in your resignation letter it is worth an examination of this product.

A year unlikely to be repeated

BetaShares describes OOO as providing investors exposure to the price of West Texas Intermediate (WTI) crude oil futures, hedged for currency exposure.

The ETF invests in oil futures which are contracts for future delivery of oil.

Futures can be used by a company that is looking to sell oil at a future date or can be used by a consumer of oil that needs that oil at a future date.

The futures are a way of locking in a price to either sell or buy that oil and remove uncertainty around changes in price. Futures contracts can also be used to gain exposure to the price movements from parties that do not want to take physical delivery of oil. That is what OOO is doing.

They will therefore sell the contract and use the proceeds to buy another contract with a delivery date further out in the future. This allows them to maintain continual exposure to the price of oil futures.

The last year was a very strange time in oil futures markets as the war in Ukraine sparked supply concerns, as did OPEC production cuts. The markets exhibited something called backwardation which is a fancy way of saying that oil futures are priced lower than the spot price of oil, which is the price for immediate delivery.

This is fairly rare since normally the price is higher for futures because the costs associated with storing the oil are applied to the spot price.

As futures contracts get closer to expiration they will get closer to the spot price. When those contracts are sold by the ETF they will therefore results in a capital gain. Backwardation causes the ETF to buy low and sell high.

And that of course results in increased distributions for investors. This should not be confused with a dividend.

The ETF only holds one asset which is the futures contracts. Futures contracts don’t provide any income. Once the oil market normalises this source of “income” should disappear.

Interestingly enough the ETF is down close 29% in the past year as oil prices retreated.

It was the nuances of the futures market that managed to generate so many capital gains in a year when the overall ETF had a significant fall in value.

Know what you are buying and why you are buying it 

Chasing yield is very similar to chasing performance. It can lead to poor outcomes if you don’t do your homework.

Executing a successful income investing strategy is the same as any other successful investing strategy. It involves understanding what you are trying to accomplish and understanding what you are in investing in.

Many investors don’t understand the details of how ETFs work which can lead to problems with using them for an income investing strategy.

As market conditions change the expected income from some ETFs may fail to materialise and there may be more volatility in income from even sound strategies.

Gaining a greater understanding of the underlying holdings in an ETF, the index construction methodology and rebalancing approach.

How I use ETFs in my income investing strategy

As outlined in the first part of this series I have employed an income investing strategy for my non-retirement portfolio.

I do use ETFs as part of this effort, but I use them sparingly. My approach is to generate a sustainable and growing income stream in excess of the yield available from the overall index.

My goal is not to exceed the return of the market but instead to grow my income faster than that of the overall market.

In periods of risk-taking and speculation when investors turn their nose up at dividends as relics of the past I fully expect to underperform. In periods of fear when investors seek a dividend paying port in the storm I expect to outperform.

My desire to exceed the yield of the overall market precludes using broad based index tracking ETFs which I feel are generally the best options for investors.

I gravitate towards factor-based income ETFs which attempt to identify high and sustainable dividends. Despite the natural diversification that comes from an ETF I keep these ETF positions only slightly larger than a single stock position in my portfolio.

The predictability and growth of the income stream generated by an ETF can sometimes be challenging.