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

One of the most disruptive trends in the asset management industry over the past 20+ years has been the growing popularity of exchange-traded funds (ETFs). When you invest in an ETF, your money is pooled with other investors' money to purchase a basket of assets. ETFs typically track a specific index, such as the S&P 500, Nasdaq Composite, or Russell 2000, so when that index is up (or down), your ETF should be up or down by roughly the same percentage.

Unlike buying individual stocks, an ETF allows you to invest in hundreds or thousands of assets through a single fund. It trades on stock exchanges, allowing you to buy and sell shares throughout the day and providing you with relative liquidity.

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Building a passive-income portfolio with ETFs is possible using a couple of methods. For example:

• Purchase a dividend-paying ETF.
• Purchase an ETF that focuses on bonds, real estate investment trusts (REITs), or another fixed income security that doesn't rely on dividends but still provides income.

Before you get started, answer these three questions to help you home in on a plan.

What are my goals?

Before diving into ETF selection, nail down your financial goals. Decide whether you're looking for long-term growth, steady income, or both. Once you clearly outline your objectives, it's a matter of choosing the ETFs that align with them.

How do I plan to remain diversified?

Diversification is essential. Even if your portfolio consists of only three or four ETFs, your investments should be spread across various sectors and asset classes. This approach protects you from the volatility associated with any single company or sector.

While aiming for a diversified portfolio, focus on ETFs that provide income-generating assets. Here are three categories to consider:

• Dividend ETFs: Funds that invest in companies with a history of paying dividends. Keep an eye out for ETFs focused on high-yield dividend stocks, such as the Schwab U.S. Dividend Equity ETF (NYSEMKT: SCHD).
• Bond ETFs: Funds that invest in government, municipal, or corporate bonds. Not only can bond ETFs provide a steady stream of income, but they are also generally considered less volatile than equity funds.
• Real estate investment trust (REIT) ETFs: Invest in income-producing real estate, which typically returns a significant portion of earnings as dividends. If you want to own real estate without the hassle of becoming a landlord, a REIT may be precisely what you're looking for.

Am I prepared to conduct routine checkups?

While ETFs are considered passive, that doesn't mean they're set-it-and-forget-it investments. You'll want to ensure that each ETF's performance continues to closely track its underlying index. You'll also need to determine when it's time to adjust or rebalance your portfolio.

ETFs are a great tool for building wealth, as evidenced by their popularity. The fact that you can build an entire portfolio around them while producing extra income is an excellent bonus.

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.