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The Case For Using ETFs In VAs

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Navigating investment risk/return tradeoffs over a lifetime can be a daily challenge for old and young alike–especially since investment risk tolerances change significantly as people mature and since average investors have little or no experience.

It may seem that availability of one sound solution–one that makes sense for consumers at any life stage–is too good to be true. However, the growth of the exchange traded fund (ETF) market has made this dream a reality. ETFs are now available in variable annuities, a development that makes the funds a smart, sound and easy retirement solution for all consumers, especially seniors.

Until recently, mutual fund-based products comprised many VA platforms. Now, ETF-based products, such as target date funds, are available to the VA market too. ETFs have become one of the most popular and viable investment vehicles today because they allow for precise measurement and management of asset class exposure. These benefits make their inclusion in VAs a smart idea.

Investment suitability for target date funds is determined with just two concrete facts: The investor’s age and expected retirement date. This is easy for the advisor to explain and easy for the investor to understand. That has helped make target date funds an essential solution to the retirement challenge.

Target date funds change an investor’s asset allocation each year, gradually growing more conservative over a time horizon of as many as 60+ years. This pattern of annual incremental allocation adjustments is often referred to as a “glide path” or “roll down.”

The aim is for consistent, risk-adjusted growth for younger clients, who need to accumulate wealth, and to protect assets in down markets for older investors who cannot afford to lose principal.

ETF-based target date funds make sense for VAs because they are lower cost and far more transparent than actively managed mutual funds. With ETFs, investors know what they own, since their fund’s “basket” of securities is published daily.

ETFs also completely eliminate several vulnerabilities of actively managed mutual funds (see chart).

While ETFs have exploded in popularity, most ETFs still have a short history. Their back-tested performance data are hypothetical, rather than true market returns. In addition, they don’t factor in trading costs, which include commissions paid to buy or sell stocks, as well as “market impact,” which refers to the way an investor may move a stock’s price by attempting to buy or sell it.

But these drawbacks are minor in comparison to the great benefits they offer consumers.

Today, more than 500 ETFs dot the market, and many cover similar market segments. So evaluating ETFs and ETF-based VAs can be overwhelming for the beginner. To make the selection easier, investors should use several basic criteria based on an analysis of structure and investment merit. Some factors include:

The construction of the index the ETF replicates. Indexes representing similar market segments can be remarkably different in terms of index provider methodology and portfolio management practices. Turnover, for example, affects the investor’s return after costs and taxes. Rebalancing (index-linked ETFs are required to change portfolio composition when the index adds/drops stocks), the timing, market impact, and transaction costs of rebalancing can also affect performance. Dividend reinvestment affects tax efficiency too, since some ETFs hold dividends in cash and pay them out to investors periodically, whereas others reinvest dividends daily.

How the ETF mirrors its index. Often the ETF provider samples rather than fully replicates a target index, using optimization techniques to create ETFs that closely track their indexes while minimizing transaction costs. Inefficient replication techniques can impact the ETF’s tracking error relative to the index and its after-tax returns.

Explicit and implicit ETF costs. Expense ratios are just one element of an ETF’s cost; implicit costs, including the investor’s commission costs and market impact costs must also be factored in the mix to arrive at the ETF’s total cost.

By keeping those factors in mind, investors can make decisions about ETFs that make sense for their life stage and investment tolerance. And now that ETFs are available to the VA market, investors of all ages, especially seniors, can head into retirement with ease of mind and a greater sense of security.

Melvin Herman is CEO of XTF Global Asset Management, LLC, New York, N.Y. He can be reached via e-mail at .


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