Should You Ditch Index Funds? Why High-Yield ETFs Might Be Better

Key Points

• High-yield ETFs offer a different type of exposure than traditional index funds and pay higher dividends.
• Index funds track a benchmark of common stocks like the S&P 500, while high-yield funds hold a mix of dividend-paying stocks, REITs, bonds, and preferred shares.
• High-yield ETFs provide more consistent income but carry more risk that investors must understand before buying.

Index funds have long been hailed as the gold standard for long-term investing—offering low fees, market-wide exposure, and steady returns. 

Developed by Vanguard founder Jack Bogle, index funds don’t attempt to beat the market. Instead, they limit expenses by tracking the market average, allowing investors to keep more capital in the market instead of paying a fund manager. While index funds have low fees and minimal volatility, they don’t provide much income through dividends.

But for investors seeking immediate cash flow or higher income, the low dividend yields of index funds can be a major letdown.

Enter high-yield exchange-traded funds (ETFs). These funds are designed to boost your dividend income, sometimes paying two to three times more than traditional index funds. But do these higher payouts come at a hidden cost?

In this article, we’ll stack up index funds against high-yield ETFs, examine their advantages and risks, and review a few popular high-yield ETFs to help you decide which strategy fits your goals.

Index Funds vs. High-Yield ETFs: A Side-by-Side Comparison

Like index funds, they are baskets of securities lumped into a single asset, but the holdings vary significantly from the traditional index benchmark. High-yield ETFs seek income distribution through dividends rather than capital appreciation, using equities, bonds, and preferred stocks to achieve their objectives. 

Before you decide whether to swap your index funds for high-yield ETFs, it’s crucial to understand what each offers. Here’s a quick breakdown to help you weigh your options.

Feature	Index Funds	High-Yield ETFs
Dividend Yield	Low (1.5%-2%)	High (4%-7%+)
Risk Level	Lower	Higher
Growth Potential	Strong (market-based)	Moderate
Volatility	Less volatile	More sensitive to market fluctuations
Expense Ratios	Ultra-low (0.03%-0.1%)	Varies (0.06%-0.6%+)
Best for...	Long-term passive growth	Passive income and dividend growth

Pros and Cons of Index Funds

When it comes to building steady, hands-off wealth, index funds offer several advantages that are hard to beat. Here’s why they remain a favorite among long-term investors:

• Broad Market Exposure: Invests in 500+ stocks across all sectors
• Lower Volatility: Less risk compared to individual stocks or high-yield assets
• Minimal Management Needed: Ideal for a hands-off investing approach

Despite their strengths, index funds aren’t perfect—especially if you’re seeking high income or better inflation protection. Here’s what you need to keep in mind:

• Lower Income Potential: Dividend yields often range from 1.5% to 2%
• Limited Downside Protection: Prices fluctuate with the overall market, offering no extra stability

Pros and Cons of High-Yield ETFs

High-yield ETFs can supercharge your passive income and provide access to asset classes that traditional index funds may overlook. Here’s why some investors make the switch:

• Higher Dividend Income: Some ETFs offer yields of 4%-7% or more
• Diversification Beyond Traditional Stocks: Includes real estate investment trusts (REITs), bonds, and dividend-growth stocks
• Inflation Protection: Dividend growth often outpaces inflation, preserving purchasing power

While the rewards can be tempting, high-yield ETFs aren’t without risks. Here’s what you should watch for before investing:

• Higher Volatility: Some funds invest in risky sectors or companies with unstable dividends
• Possible Dividend Cuts: High yields can be unsustainable if companies struggle
• Higher Expense Ratios: Fees may be higher than traditional index funds

Why Some Investors Prefer High-Yield ETFs

More investors are turning to high-yield ETFs as a way to generate dependable income and hedge against inflation. Here’s what makes them a compelling alternative:

Higher Passive Income

One major benefit of ETFs is that you can package different types of investments into a single wrapper. Index funds have low fees because there’s no research and management team to pay—the fund simply tracks the underlying benchmark, outsourcing all decisions to the index. However, index funds are usually considered a vehicle for long-term growth and are not something you can rely on for steady income. 

High-yield ETFs focus on income through dividends, not matching market returns. Index funds tracking benchmarks like the S&P 500 offer an average 1.5% dividend yield, but high-yield funds often average between 4% and 7%. This steady yield is a better approach for conservative investors than unpredictable market returns.

Alternative Asset Exposure

Index funds track thousands of different benchmarks, each with a prospectus laying out the fund’s thesis and objectives. However, with markets becoming more top-heavy, many index funds simply repackage the same stocks in different allocations.

Large-cap tech takes up a considerable portion of most index fund holdings as companies like Apple Inc. NASDAQ: AAPL, Amazon Inc. NASDAQ: AMZN, and Microsoft Corp. NASDAQ: MSFT continue to grow and grow. 

It's hard to get away from the Magnificent 7 if you’re investing in U.S. equity index funds. However, high-yield ETFs offer different types of asset exposure, such as REITs, international dividend stocks, and fixed-income securities. Diversifying into high-yield ETFs can provide income stability when index funds dip during market drawdowns.

Better Inflation Protection

High-yield ETFs aren’t the ideal inflation hedge—Treasury Inflation-Protected Securities (TIPS) are better—but they offer some level of protection that index funds do not. High-yield funds often invest in assets that perform well during periods of high inflation.

For example, if the Federal Reserve raises rates to quell inflation, bond yields will rise, and high-yield ETFs can increase dividend payouts to investors. Additionally, the stocks in high-yield ETFs often have strong dividends and customer loyalty and can pass on their increased input costs.

Top High-Yield ETFs to Consider

Looking for the best options to start earning higher income today? Here are three standout high-yield ETFs worth adding to your watchlist:

1. Schwab U.S. Dividend Equity ETF 

Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD) tracks the Dow Jones U.S. Dividend 100 Index, which comprises 100 of the country's biggest dividend-paying companies.

The fund’s holdings are evenly distributed among different stock sectors, with healthcare having the most prominent representation at 17%.

This is followed by consumer staples (14.5%), financials (14.4%), energy (11.5%) and tech (11.1%).

The fund currently yields over 9%, and the stocks in the basket have strong fundamentals.

• Dividend Yield: 9.21%
• Expense Ratio: 0.06%
• Top Holdings: Home Depot, Verizon Communications, Cisco Systems

2. Global X SuperDividend ETF

Global X SuperDividend ETF NYSEARCA: SDIV has a unique basket of stocks that can provide genuine diversification from traditional index fund assets.

Many of the fund’s holdings aren’t traded on U.S. stock exchanges, such as Yue Yuen Industrial Limited (a footwear company in Taiwan), HKBN Ltd (a telecom company in Hong Kong), and Van Landschot Kempen (a bank in the Netherlands). The fund charges a hefty expense ratio for this exposure, but finding these stocks in a different wrapper is challenging. The nearly 7% dividend yield isn’t too shabby, either.

• Dividend Yield: 6.95%
• Expense Ratio: 0.58%
• Top Holdings: Global high-dividend stocks, REITs, and utilities

3. iShares Preferred & Income Securities ETF

iShares Preferred & Income Securities ETF NASDAQ: PFF holds a basket of preferred stock from companies like Boeing, NextEra, Bank of America and Hewlett-Packard.

Preferred stock is a hybrid asset—part equity and part debt. Unlike common stock, preferred shares have no voting rights, and the dividend yield is often set based on the share's par value. Preferred stock has a more senior bankruptcy claim than common stock but is still less senior than bonds. Some of the holdings are convertible stock, meaning preferred shares that can be converted to common shares if certain conditions are met.

• Dividend Yield: 6.23%
• Expense Ratio: 0.46%
• Top Holdings: Preferred shares from major institutions

Who Should Stick with Index Funds?

Choosing between index funds and high-yield ETFs largely comes down to your goals and risk tolerance.

Index funds are probably better for you if you:

• Prefer a Hands-Off Approach: Investing in index funds means you don’t need to track market news or economic data. Since index investors have a long-term approach, they can ride out market downturns and adjust asset allocation a few times yearly (if at all). There is no need to track dividend changes or sector performance.
• Want Lower Risk and Volatility: Index funds typically have a more diverse collection of holdings, which minimizes risk and allows the portfolio to recover well over time. Index funds won’t protect from bear markets, but the volatility is more manageable.
• Have a Long Investment Horizon: Stacking wins is critical for younger investors, who can benefit from capital appreciation over timelines spanning decades. If you begin index investing early, you can transition to high-yield ETFs later and live off your dividend income.

On the flip side, high-yield ETFs might be better for you if you:

• Want Higher Income Right Now: If you want consistent payouts from your investments, high-yield ETFs can provide them. This is important for retirees or investors living on a fixed income who prefer steadiness to higher (but fluctuating) returns.
• Need Cash Flow: Retirees can use dividend payouts to supplement living costs, maximizing their nest egg and making their money last longer. Cash flow from high-yield ETFs can prevent savers from tapping other income sources that might come with penalties or taxes (like an early distribution from a traditional IRA).
• Can Handle More Volatility: High-yield ETFs offer consistent dividend payments, but that doesn’t mean the same amount each time. Some sectors (like REITs and financials) fluctuate more rapidly than the S&P 500, which could reduce or increase a fund’s yield. Always understand the fund’s objectives in the prospectus and be prepared to alter your allocation if market conditions change.

So, Should You Ditch Index Funds?

If investing were a one-size-fits-all endeavor, we wouldn’t need financial advisors or market analysts since everyone would pursue the same goals. However, the market comprises millions of investors acting in their best interests, so determining your objectives is crucial in investment management.

Are you looking to build a capital cushion for retirement or another long-term goal? Index funds are probably your best choice since they maximize capital growth and don’t reduce risk in market downturns. But if you want to see quarterly or biannual payments in your brokerage account, consider high-yield ETFs. You’ll get better inflation protection than traditional ETFs, and you can always use a combination of both for capital appreciation AND income.

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