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Investors are flocking to tax-efficient ETFs

Exchange-traded funds continue to surge in popularity, thanks in no small part to their appeal among investors who need income from their portfolios.

In simplest terms, ETFs — of which there are now nearly 2,000, with $2.4 trillion under management — are investment funds that trade on stock exchanges and can be bought or sold throughout the trading day at fluctuating prices.

Like mutual funds, they can be used by income-oriented investors to gain exposure to bonds of all types — from high-quality corporate debt to junk — and dividend-paying stocks. Most ETFs are passively managed, meaning they track an index or components of one.

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As such, they tend to be more tax efficient and have lower annual fees than mutual funds, which are largely actively managed. That cost advantage has given ETFs a leg up with investors in the low-yield environment that has persisted since the financial crisis.

"The lower the costs, the more income available for the fund to distribute to shareholders," said Richard Powers, head of ETF product management at The Vanguard Group. "This is important in any environment, but especially in a low-interest-rate environment."

There is no shortage of ways to use ETFs for income investing, and, of course, each strategy has trade-offs in terms of risk and reward. One technique that has gained traction among advisors is to use a distinct breed of ETFs — defined-maturity bond ETFs — to create laddered bond portfolios. The ETFs hold bonds that have roughly the same maturity.

Traditionally, laddering has entailed building a portfolio of individual bonds with staggered maturities so that portions of the portfolio mature each year. Investors can take out the proceeds from maturing bonds or, if interest rates rise, reinvest that money at higher rates.

"People are looking to supplement the yield they're getting from traditional fixed income by adding or rotating into these high-yield or alternative fixed-income products." -Elliot Van Ness, director of research and portfolio manager, Rinehart Wealth & Investment Advisory

Building a laddered portfolio made up of defined-maturity bond ETFs — such as the popular Guggenheim BulletShares family — has several advantages over the traditional route. For starters, investing in funds versus buying individual bonds offers a greater level of diversification, so in theory it's less risky.

"We've really fallen in love with the Guggenheim BulletShares," said David Hunter, a certified financial planner and principal at Horizons Wealth Management, a fee-only firm.

"They're very easy to trade, with lower transaction fees than bonds or [traditional] bond funds, all the while providing diversification," he added.

Investors have also piled into ETFs that own dividend-paying stocks. These generally fall into two camps, said Ben Johnson, director of global ETF research at Morningstar.

The first camp — which Johnson calls the growers — is comprised of ETFs investing in companies that have maintained and grown their dividends over time. Such funds include the Schwab U.S. Dividend Equity ETF, the Vanguard Dividend Appreciation ETF and ProShares S&P 500 Dividend Aristocrats. Investors in these funds, said Johnson, need to keep in mind that they may be in store for a bumpy ride.

"Valuations matter, and high-quality dividend-paying stocks look fairly rich," he said. "Secondly, stocks are not bonds," Johnson added. "This is equity risk you are assuming, and it will be accompanied by equity-like volatility."

The next camp — which Johnson calls the yielders — is made up of ETFs investing in companies paying higher-than-normal dividends. These firms tend to compensate investors for the fact that their dividends may not be sustainable based on current fundamentals or future performance.

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"The yielders have equity-like risk that is probably higher than broad stock-market risk," said Johnson, referring to ETFs such as Vanguard's High Dividend Yield ETF. "It is certainly higher than the level of volatility you would experience with a portfolio made up of dividend growers."

Indeed, the hunt for yield has driven investors to some of the most volatile corners of the ETF universe, whether it's the junk bond market or master limited partnerships owning companies involved in energy exploration, production or transportation.

"People are looking to supplement the yield they're getting from traditional fixed income by adding or rotating into these high-yield or alternative fixed-income products," said Elliot Van Ness, director of research and a portfolio manager at Rinehart Wealth & Investment Advisory, a fee-only firm.

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Such funds have the potential to enhance the performance of a diversified portfolio. But they also may take investors on a wild ride, which is particularly unnerving if you're retired or nearing retirement. Over the past year, some ETFs with a strong following among yield-starved investors have endured eye-popping volatility.

From mid-2015 to early 2016, the iShares iBox $ High Yield Corporate Bond ETF, for instance, lost about 13 percent of its value, owing to the fallout in the energy sector. The energy-sector crunch also caused the Alerian MLP ETF to lose roughly 50 percent of its value from its highest to its lowest point last year.

"There's really no free lunch in income investing: The higher the yield, the higher the risk," said David Fabian, managing partner and chief operations officer at FMD Capital Management.

— By Anna Robaton, special to CNBC.com

Correction: This story has been updated to reflect that there are currently nearly 2,000 ETFs, with $2.4 trillion under management.