In the latest Selfwealth Live, Big Dividends: Metcash Vs. Vanguard VHY, I took an in-depth look at how to draw a passive income from your portfolio, how to use dividend ETFs and the age-old 'Rule of 4%'.

Rule of 4%

Let's start at the top. It's widely considered by long-term investors that a 'safe withdrawal rate' is around 4% of a portfolio.

Meaning, an investor could take 4% from their diversified portfolio and still maintain a healthy balance. For example, an investor who has just hit retirement might have $1 million across their brokerage and Superannuation. Using the 'rule of 4%', the investor might be able to draw 4% (or $40,000) per year to sustainably replace their retirement income.

This rule of thumb needs some checking, however. In order to draw a 4% income from your investments — and maintain your portfolio — this rule assumes two things:

1. Your portfolio achieves an after-tax return of 7%;

2. Inflation is no higher than 3%.

Think about it like this: 7% return minus 3% inflation equals a 4% increase in the value of your portfolio. Going back to our example, it would be $70,000 of gains less $30,000 eaten by inflation, leaving the investor with their $40,000 of income — and they still have $1 million in the portfolio (plus the $30,000 that accounts for inflation).As I showed in the Selfwealth Live session, shown above, it may be tough to get 7% after-tax returns from a portfolio given how high asset prices are right now and given that inflation is currently around 5%. Using the 4% Rule it would be 7% - 5% = 2% safe withdrawal rate. However, the good news is I haven't included franking credits in my example of 7% returns (which are a massive help to Aussie investors) and the high inflation we're currently experiencing could slowly subside if the RBA keeps hiking interest rates.

Passive income

Typically, income can be drawn from a portfolio in one of two ways:

1. Dividends (shares) or distributions (ETFs and managed funds) received

2. Capital growth (your investment increasing in price) and selling some of the gains

The best investments, like Commonwealth Bank (ASX: CBA) or ARB Corporation (ASX: ARB) over the past 30 years, do both — increase in value and pay income. However, in my experience, the vast majority of companies struggle to maintain a steady dividend while also growing their business.

There is where, I believe, exchange-traded funds or ETFs can fill the void.

ETFs are not perfect from a tax perspective and there are some poor-quality ETFs on the market. Particularly in the thematics space.

However, good Aussie shares ETFs offer diversification, low costs and dividends with franking credits which can be 'passed through' to the end investor. There then are some ETFs specifically set-up to target dividend-paying stocks.

For example, a dividend ETF could set a rule: "buy all Australian shares with a dividend over 3% and avoid shares with no dividend." This would ensure the ETF only holds shares of companies that pay dividends to investors. (Obviously, it can get a bit more complicated than that but you get the gist of it.)

Dividend ETFs

One key finding from studying the Australian shares ETFs that target dividends, shown above, is that diversification is important. For example, I think some of the better dividend ETFs, like Vanguard Australian Shares High Yield ETF (ASX: VHY) or iShares S&P/ASX Dividend Opportunities ETF (ASX: IHD), offer a good number of holdings inside the ETF plus they limit exposure to sectors or individual companies (e.g. no more than 30% invested in bank stocks). Meaning, the distributions paid by these diversified ETFs should be more consistent over time given they have more companies inside of them. Another thing is fees. While this is more of a heuristic or something that I've noticed from other sectors over time, lower fees tends to equal higher returns. Although you could argue the BetaShares ASX 20 Dividend Harvester (managed fund) (ASX: YMAX) may become an exception to this. It's still early days for YMAX. Finally, a lot of Selfwealth Live viewers wondered why the share prices of the dividend ETFs often go backwards or even just sideways, yet I quoted positive returns between 2% and 11% (see above). The answer is that my return calculations (and those from the ASX) take into account capital gains (from the share price) plus dividends. In other words, total returns. It's vital you study the total returns when looking at these ETFs because dividends are not captured by the share price. In most years I'd expect the majority of your return from these ETFs to be in the form of dividends — given that's what they're targeting.

Dividend ETFs: Core or Satellite?

At the end of the day, the best dividend ETFs could be considered as part of the Core or added to the satellite positions you hold (e.g. smaller position with a 3-year time horizon as opposed to 10 or 20 years in the Core). For example, I'd happily use Vanguard VHY for the Australian Shares part inside a Core portfolio. VHY is low cost and has adequate diversification by holdings (60+ holdings). However, it probably shouldn't be mixed too heavily with another vanilla Aussie shares ETF (e.g. VAS or A200) which also has high exposure to financials/banks.More pricey dividend ETFs or those with less diversification (MVB, YMAX, DVDY, etc.) might be decent tactical/satellite positions because, over time, I would expect more volatility from these ETFs.

Don't forget to tune into the next Selfwealth Live by hitting 'subscribe' on the YouTube Channel. That way you'll get a notification the next time I go live on the channel. Owen Raszkiewicz is the Founder of Rask, a platform helping Aussies invest better. You can take a free course on Rask Education, or follow Owen on Twitter and Instagram. This article contains general financial information only, issued by The Rask Group Pty Ltd. The information does not take into account your needs, goals or objectives, so please speak to a financial adviser before acting on the information.