The stock market has been on a tear over the past couple of years. The S&P 500 is on track to deliver back-to-back years of more than 20% gains, while the tech-heavy Nasdaq-100 index has nearly doubled since the start of 2023. While the market could pull back at some point in the next year, its long-term trend is to shake off any declines and keep setting new highs.
Investors could just buy exchange-traded funds (ETFs) focused on the S&P 500 or Nasdaq-100 in hopes of a continued rally. However, a smarter play would be to buy ETFs set to benefit from a notable catalyst in 2025. A potentially big one is falling interest rates, as the Federal Reserve continues to lower the benchmark federal funds rate (even if the pace is slower than expected). That should benefit income-focused funds, like those that hold dividend-paying stocks, bonds, and real estate. Here are three smart ETFs to consider buying to capitalize on this potential catalyst in the coming year.
More income for a value price
Dividend-paying stocks have underperformed the market this year. That's due in part to interest rates, which continue to weigh on the valuations of higher-yielding dividend stocks. For example, the Schwab U.S. Dividend Equity ETF(NYSEMKT: SCHD) was already underperforming the S&P 500's total return before its recent dip:
In the process, the difference in valuation between the two has grown wider. Schwab's ETF trades at an average price-to-earnings ratio of 18.4, much cheaper than the broader market index, whose tech-heavy makeup gives it a ratio of 25.8.
The dividend ETF also offers a much higher dividend yield -- 3.3%, compared to 1.2% for the S&P 500. To put some numbers behind that yield, a $1,000 investment into this fund would produce around $33 of dividend income in 2025. That compares to only $12 in an S&P 500 index fund. That higher income stream will help cushion the blow if there's a market correction next year.
That income stream will likely rise over the next year, given the fund's focus on high-quality, high-yielding dividend stocks that have excellent records of increasing their dividends. On top of that higher income, the value of the Schwab U.S. Dividend Equity ETF should rise as rates fall, adding to the fund's total return potential.
A low-risk income stream
Bonds are very sensitive to changes in interest rates, increasing in price when rates fall. Because of that, bonds could produce higher total returns next year if the Federal Reserve continues to cut rates.
The Vanguard Total Bond Market ETF(NASDAQ: BND) is a great way to broadly invest in the bond market. The fund holds over 11,300 bonds. The U.S. government backs nearly 70% of its holdings, while the remaining bonds are from investment-grade corporate issuers. That makes these bonds very low-risk investments.
The bonds currently have an average yield to maturity of 4.6%. At that rate, a $1,000 investment will produce about $46 of interest income over the next year. On top of that, the value of the bonds should continue rising as rates increase, adding to an investor's total return potential in the next year.
Income and upside from real estate
Like bonds and dividend stocks, the value of commercial real estate is very rate-sensitive. Real estate values have fallen in recent years due to higher rates. However, with rates starting to decline, commercial real estate values should recover over the next year.
The Vanguard Real Estate ETF(NYSEMKT: VNQ) is a great way to invest in a potential real estate recovery. The fund primarily invests in real estate investment trusts (REITs), entities that own large commercial real estate portfolios. The fund currently holds over 150 REITs.
REITs typically pay above-average dividends because the IRS requires that they distribute at least 90% of their taxable net income to investors each year. As a result, the fund currently offers an attractive income yield of 3.3%.
In addition to that dividend income, the fund's value should rise next year as real estate values improve. That could enable the ETF to produce strong total returns. Over the very long term, REITs have historically outperformed stocks. With their values down right now, there's an even higher probability that REITs will outperform stocks from here.
Compelling investment options for 2025
The Federal Reserve appears poised to continue cutting interest rates next year, even as officials have lowered their expectations from four cuts to two. That catalyst should boost the values of income-generating investments like dividend stocks, bonds, and real estate. As a result, ETFs focused on those investments like Schwab U.S. Dividend Equity ETF, Vanguard Total Bond Market ETF, and Vanguard Real Estate ETF look like smart buys as we head into the new year. They could outperform broader-market ETFs if stocks take a breather.
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Matt DiLallo has positions in Vanguard Total Bond Market ETF. The Motley Fool has positions in and recommends Vanguard Real Estate ETF and Vanguard Total Bond Market ETF. The Motley Fool has a disclosure policy.
