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5 reasons why retirees are embracing ETFs

Christine Benz  |  26 Apr 2019Text size  Decrease  Increase  |  
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Millennial investors were more likely than investors in other age groups to own exchange-traded funds, according to a US survey conducted by investment provider BlackRock.

Among investors aged 21 to 35, 42 per cent said they owned ETFs in 2017, up from 33 per cent of investors in that same age group who said they had ETFs in their portfolios the year prior.

Given that ETFs are a new(er) investment innovation, it’s probably not surprising that the youngest investors would embrace them.

What’s unexpected, however, is just how much ETFs have found a home in the portfolios of what BlackRock calls “Silver”-aged investors – people over age 70.

Some 37 per cent of investors within that age band said they owned an ETF in 2017, up from 22 per cent a year earlier. That’s a higher uptake than among generation X investors, 29 per cent of whom said they own ETFs, compared with 27 per cent of baby boomers.

While older adults are often characterised as slow to adopt new products and services, that’s definitely not the case with ETFs.

Older adults’ embrace of ETFs may have something to do with the fact that, as retirement approaches, many investors look at their portfolios with a fresh set of eyes and make adjustments accordingly.

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A portfolio that was geared toward growth in all of those working years is now being tasked with a different job – providing cash flows for living expenses in retirement.

That necessitates changes to the portfolio’s asset allocation, which may in turn prompt changes to the underlying investments in the portfolio.

Of course, active funds can work well in retiree portfolios, too, provided they’re of the very low-cost variety.

My baseline model bucket portfolios – geared toward people who are retired – include both actively managed and index funds. Yet the more I work with in-retirement portfolios, the more I like ETFs and traditional index funds for the job, for the following reasons:

1. Index funds and ETFs lend themselves well to cash flow extraction.

Retired investors can employ one of two key tacks to extract cash for living expenses from their portfolios: an income-centric approach or a total return/rebalancing approach, or a combination of the two. The good news is that index funds and ETFs lend themselves well to either.

For income-centric retirees, the small fees that index funds and ETFs typically levy ensure that more of their dividends flow through to shareholders. It’s all but impossible for more-expensive products with similar mandates to generate a competitive yield without taking on additional risk.

For total-return-oriented retirees who are using rebalancing – trimming appreciated securities – to meet living expenses, index funds and ETFs also work well. That’s because they are typically pure plays on a given asset class.

That makes it simple to identify which assets need to be scaled back to deliver the retiree’s desired cash flow and restore the portfolio to its desired asset-allocation mix.

In late April 2019, for example, most index-fund investors who need cash from their portfolios will be able to extract it by selling appreciated U.S. equity holdings, and they’ll reduce risk in the process.

2. Maintenance is simple.

In addition to making it easy to extract cash flows, index funds and ETFs also stack up well in terms of limiting a retiree’s oversight obligations.

That's an important consideration, given that many retirees have better things to do with their time than monitoring the news flow related to their holdings.

Yes, retirees employing index funds will need to keep tabs on their total portfolios’ asset-allocation mixes. But very little changes with most core-type index funds and ETFs on an ongoing basis.

While a firm’s general indexing acumen is important, who’s actually managing an ETF or index fund is less important than is the case with actively managed funds. Index fund and ETF expense ratios are generally pretty stable, too; if anything, they’ve been trending down over the past decade.

Finally, because index funds don’t make active bets, investors employing total market index products won’t find their total portfolios listing toward a single sector or part of the style box. Such investors will still need to oversee their overarching asset-class exposure, but they won't need to micromanage smaller-bore portfolio bets.

3. It's not hard to control a portfolio's risk level with index funds and ETFs.

Many retirees prize risk controls, and one comment I sometimes hear of active funds is that they’ll earn their keep in down markets.

Below are some Australian examples of lower-risk index products popular for their focus on income-generating stocks, including franking credits:

- Russell High Dividend Australian Shares ETF (RDV)
- Vanguard Australian Shares High Yield (VHY)
- iShares S&P/ASX High Dividend ETF (IHD)

Perhaps an even more important point is that even though mild-mannered funds can help lower a portfolio’s overall risk, the most dependable way to move the needle on a portfolio’s volatility level - and indeed its potential for real losses - is by adjusting the stock/bond mix, not the underlying holdings.

4. The tax-efficiency stakes may be higher.

Taxes are another area where the advantage accrues to index funds and ETFs in retirement. While bond index funds and ETFs have no special tax advantages relative to actively managed bond funds, equity index funds and especially ETFs are incredibly tax-efficient relative to their actively managed counterparts.

Of course, managing for tax efficiency is important at every life stage, but it's arguably most important in retirement. For one thing, investors' portfolios are often at their largest right before and during retirement; the share of the portfolio parked in taxable accounts is also apt to be highest at that life stage.

5. Lower-return portfolios need low-cost products.

Finally, low-cost products make a ton of sense in retirement simply because holding more cash and bonds will tend to lower a portfolio's return potential; keeping expenses low helps ensure that a higher share of the returns flows through to the investor.

Assume a retirement portfolio consists of a 10 per cent cash position, 40 per cent in bonds and 50 per cent in stocks. If market return forecasts hold, that portfolio’s return won’t likely crack 5 per cent over the next decade.

If an investor pays 0.75per cent in asset-weighted expenses on such a portfolio, her return shrivels to 4.25 per cent; she has ceded 15 per cent of her gains. But if she’s able to limit expenses to 0.10 per cent annually, her take-home return is 4.9 per cent and she has surrendered just 2 per cent of her return.

As Vanguard founder Jack Bogle put it, you get what you don’t pay for, and not paying for investments is especially important when returns aren't especially high to begin with.

is Morningstar's director of personal finance.

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