Here's How to Build a Passive Income Portfolio With ETFs

There are plenty of reasons exchange-traded funds (ETFs) appeal to investors. First, it's easy to know what you're buying because they track specific indexes, and second, ETFs typically have low ongoing costs. Simply due to the options available in the ETF market, it's entirely possible to build a complete and balanced ETF-only portfolio.

Here's what you need to know about creating one yourself.

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Weigh your risk tolerance

The first step is to determine how much tolerance you have for taking investment risks. If you're very close to retirement or simply can't relax knowing that you're invested in high-risk holdings, you may want to focus on broad-market ETFs. Broad-market ETFs provide instant diversification by tracking indexes that cover hundreds or even thousands of stocks across all markets and sectors.

Let's say you're not a big fan of risk, but you are interested in healthcare stocks. A broad-market ETF is likely to include the top-performing healthcare stocks, but unlike with a sector-specific ETF, your entire ETF isn't dependent on healthcare doing well.

Choose the right types of ETFs

A well-balanced passive-income portfolio usually blends categories. While you can choose as many ETFs as you'd like to include, you can also keep it as simple as buying two ETFs. For example:

• A total world stock market ETF: Index funds that track global benchmarks from the U.S., developed countries, and emerging markets. One example is the Vanguard Total World Stock ETF (NYSEMKT: VT), which has 10,041 holdings and a year-to-date return of 10.48% (as of June 11).
• A total bond market ETF: Tracks the performance of a broad, diversified index of bonds. An example is the iShares Core U.S. Aggregate Bond ETF (NYSEMKT: AGG), which covers everything from Treasury bonds to mortgage-backed bonds and investment-grade corporate bonds.

Income-producing ETFs

If you're hoping for income, prioritize dividend-paying ETFs. However, if you're relatively young and still growing your portfolio, you may be better off accumulating ETFs that automatically reinvest earnings. One thing to keep in mind is that, unlike bond coupon payments, ETF dividend payments are not guaranteed.

Before determining how many ETFs you'd like in your portfolio and which combination of ETFs fits your goals and risk tolerance best, it may pay to work with a financial advisor. A financial advisor can run various scenarios for you to illustrate potential outcomes.

The bottom line is this: Not only is it possible to fill a portfolio exclusively with ETFs, but it may also be the right move for you.

Dana George has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.