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How to Build an Income-Focused Equity Portfolio With ETFs

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The U.S. bond market is in a tough spot amid the aggressive monetary tightening policy adopted by the Federal Reserve. The central bank hiked the benchmark interest rates by 50 basis points on May 4, matching market forecasts. However, the hike still highlights the biggest interest-rate increase since 2000.  Quelling investor projections of a 75-basis point hike, the Fed has indicated that it plans to keep the pace same for rate hikes over the next couple of meetings. The central bank also plans to start reducing its huge $9-trillion balance sheet, comprising primarily of Treasury and mortgage bonds, from June this year.

Moving on, the benchmark 10-year Treasury note yield surged to nearly 3.04% in afternoon trading on May 5, touching the highest mark since 2018. The 30-year Treasury bond yield also increased to roughly 3.126%. It is a known fact that the bond yields move inversely to prices.

The current bond market has left investors scurrying for alternative investment options that offer good yields. Investors have also started to reconsider the traditional 60/40 portfolio model (60% in equities, 40% in bonds). In such a scenario, Jon Maier, CIO of Global X, has discussed on CNBC’s ETF Edge about  some equity income alternatives to focus on over bonds.  Let’s delve deeper into his suggestions to build a bond proxy-type portfolio that is not largely governed by interest rate movements:

Opt for Quality Dividend ETFs

Generally, rising rate environments do not bore well for dividend-paying stocks. However, in the current environment, rates are being hiked to curb high inflation levels. Moreover, investors have a defensive sentiment due to the potential of an economic recession in the United States. Thus, investors are searching for alternative sources of yields that can generate steady cash flows. Traditionally, quality dividends can be more value-oriented investments.

In this regard,Maier has noted that “The market is rewarding that at least on a relative basis. And I think that’s a safer place to be than some other sectors and abroad,” per a CNBC article.

Market participants can consider ETF options that consist of stocks capable of consistently increasing dividends along with keeping steady cash flows. Thus, Vanguard High Dividend Yield ETF (VYM - Free Report) and the iShares Core Dividend Growth ETF (DGRO) look good according to the above discussions (read: A Guide to the 10 Most-Popular Dividend ETFs).

Invest in MLP ETFs

Master limited partnerships, or MLPs, are popular among investors for having relatively consistent and predictable cash flows. This feature makes them appear safer than the other investment vehicles in the broader energy space. These share a high correlation with crude oil prices and gained from the rally in the commodity’s prices this year. In addition to high yields and the potential for capital appreciation, MLPs have lower volatility and provide diversification benefits to the portfolio.

Meanwhile, MLP ETFs may provide fewer tax benefits than pure-play MLPs as they are taxed on the corporate level, per a CNBC article. However, one good point is that they do not require filing complex K-1 tax forms.

Commenting on the MLP ETFs, Maier has said that “That’s one of the reasons that investors like the ETF structure with MLPs. MLPs and LPs (limited partnerships) are highly correlated to the movement in interest rates. So as interest rates go up and up, [they] also potentially could go up,” according to a CNBC article.

MLPs represent an attractive investment option for income-focused investors. To gain exposure to the space, investors can consider Global X MLP & Energy Infrastructure ETF (MLPX - Free Report) , Alerian MLP ETF (AMLP - Free Report) and First Trust North American Energy Infrastructure Fund (EMLP). These have returned about 26.8%, 26.4% and 11.9%, respectively, so far in 2022.

Target Yields of REITs ETFs

Investors might frown at the prospect of investing in REITs amid the rising rate environment. However, these investment vehicles can provide equity exposure while consistently paying dividends and providing good diversification benefits. Moreover, REITs provide good exposure to growth-oriented areas like data centers and cellphone towers that are well-positioned to gain from an improving economy.

Investors can therefore keep a track of ETFs like Vanguard Real Estate ETF (VNQ - Free Report) , Schwab US REIT ETF (SCHH - Free Report) , Real Estate Select Sector SPDR Fund (XLRE) and iShares U.S. Real Estate ETF (IYR) (read: Will REITs Continue Their Rise During Interest Rate Hikes?).

Get Exposure to Covered Call ETFs

The two-part options strategy is witnessing higher demand. This strategy allows investors to take sell positions in call options against stock on a share-for-share basis while purchasing the exact quantity of the underlying security, according to a CNBC article.

Maier has also mentioned that covered call funds are great for use in a range-bound market, as stated in a CNBC article. He also commented that “You’re somewhat cushioned on the downside depending on the volatility in the market.” He has even stated that the convenient structuring and higher income make it worthy of paying higher price for the covered call funds. According to the same article, Maier mentioned that investors should focus on a total return perspective and cautioned that this investment strategy is susceptible to a downside from lower volatility.

Investors can consider Global X Nasdaq 100 Covered Call ETF (QYLD - Free Report) , Global X S&P 500 Covered Call ETF (XYLD - Free Report) and Amplify CWP Enhanced Dividend Income ETF (DIVO) (read: Trade Market Uncertainty With Low-Volatility ETFs).

Consider Preferred Stock ETFs

Another investment class that is gaining attention from investors is Preferred stocks. These equities have some bond-like features as they provide a payout in the form of coupons and preferred dividends. The preferred stocks mostly belong to the cyclical banks and the financial sector.

However, this investment class has been underperforming so far this year. In this regard, Maier has said, “They’re long-duration instruments, so if rates go up, the long end of the curve goes up. Inevitably these are going to go down in price, but the underlying credits are strong,” per a CNBC article.

Notably, iShares Preferred and Income Securities ETF (PFF - Free Report) , First Trust Preferred Securities and Income ETF (FPE - Free Report) , Invesco Preferred ETF (PGX) and Global X U.S. Preferred ETF (PFFD) are some ETF options investors can consider.

Conclusion

Together, these ETFs can help build an income-focused equity ETF portfolio. However, it does not exclude investors from the inherent risks of investing in equities. According to experts, one can dilute these risks to some extent by keeping a small proportion of ultra short-term and short-term corporate bond ETFs like JPMorgan Ultra-Short Income ETF (JPST - Free Report) and Vanguard Short-Term Corporate Bond ETF (VCSH - Free Report) in the portfolio.