IRA Rollover Boom Spells Opportunity for ETFs: Finke

If a client is seeking income from a taxable account, the better options are municipal bond ETFs or equity ETFs that pay a high tax-advantaged dividend yield. Fagan sees more advisors relying on taxable ETF strategies “that may include core dividend assets and other income generating securities such as preferred stock.”

Bond ETFs have grown in popularity and higher-yield corporate funds with modest expense ratios can be particularly attractive when held within an IRA. Despite a retiree’s desire for income in retirement, this income can be very expensive when bond funds are held within taxable accounts that kick out payments subject to a high ordinary-income tax rate.

In a recent debate with BlackRock CEO Larry Fink, hedge fund manager Carl Icahn criticized bond ETFs as a potentially risky investment that may be vulnerable to a sudden fall in pricing (for example brought about by a spike in interest rates). If investors all want to pull money out of bond funds at the same time, the ETF will be forced to sell a boatload of illiquid bonds in a market that may not be able to absorb it.

In reality, the argument against bond ETFs doesn’t seem to hold water. First, what else are you going to hold? If there is a selloff of bonds and their illiquidity drives down prices, you’ll still get hurt. And bond mutual funds are also vulnerable to a flood of redemptions; if they have to pay fund investors, they’ll also have to liquidate their bond portfolio in a hurry.

Two important characteristics of ETFs may increase their appeal in a bear market for bonds. First, ETFs make up only a small fraction of the bond market, so a selloff of bond ETFs should create an inordinate amount of downward price pressure. Second, the sale of an ETF won’t necessarily require the sale of the underlying bond security. Shares of the ETF are traded in the secondary market by financial firms that make money on the spreads without requiring the purchase or sale of the underlying security.

In fact, Fagan notes that “if you look at a fund like HYG, which is our high-yield ETF, there’s so much liquidity today that it’s almost become a proxy for the high-yield market. So much of it trades over an exchange where buyers and sellers are meeting that there is very little impact on the underlying fund itself because of the amount of liquidity that exists on the secondary market.”

This sentiment is echoed by Peter Fisher, senior director of the BlackRock Investment Institute, who notes that “I’ve concluded that bond ETFs have these different mechanisms for dealing with liquidity risk which give them an advantage over simply holding the underlying instruments themselves.” The meeting of sellers with buyers on an exchange to trade shares of an ETF adds to the liquidity of the ETF bond market compared to an over-the-counter market of individual sellers.

While bond ETFs may not be a source of great concern, Blanchett warns advisors to recognize the risk of investing in more exotic ETFs within taxable accounts. These ETFs can be “much less tax efficient,” notes Blanchett. Don’t assume that because assets are held within an ETF, they will automatically make sense in a taxable account.

Single ETF Solution?

While more complex retirement portfolio strategies may work for retirees who can rely on the expertise of a financial advisor, what about the many Americans who are used to a single target-date investment solution that provides an easy, low maintenance, diversified, balanced portfolio? Is there an ETF for an IRA that can serve the same purpose as a life-cycle fund in a 401(k)?

Enter the new category of so-called multi-asset ETFs that contain a mix of investments meant to provide a more comprehensive portfolio solution in a single ETF. In addition to stocks and bonds, multi-asset ETFs can include assets such as REITs, commodities and preferred stock in order to provide a well-diversified, low-cost portfolio. In some ways, a multi-asset ETF can serve as a low-cost, ready-made solution to a diversified portfolio that otherwise would have been prepared by a wealth manager.

There aren’t any rules about what a multi-asset ETF should look like, and characteristics such as risk, asset allocation, income and fees range considerably. Since target-date ETFs were largely a failure, there may be some resistance among ETF sponsors to creating a multi-asset ETF that serves as a target date replacement among retirees. The increasing popularity of multi-asset ETFs, whose assets have grown exponentially in the last 5 years, provides some evidence that the timing might be right for a single solution ETF tailored to a retiree’s life cycle.

What would a retirement life-cycle ETF look like? The first question is whether the asset allocation should change as a retiree ages. Blanchett thinks that “people tend to become more risk averse as they age, which would suggest a decreasing glide path.” Another approach is to consider a retiree’s pension benefits and Social Security as a bond-like asset that is depleted as they age. Maintaining a balance of stocks and bonds as bond-like pension wealth falls in value would also require a declining equity glidepath.

An ideal single-product ETF probably can’t exist without the help of a financial advisor who can build a portfolio strategy using ETFs and other investments, and who can locate ETFs efficiently within a taxable and tax-sheltered portfolio. It’s easier to have a single-product solution with a tax-sheltered retirement plan than it is to spread a single solution among accounts used in retirement.

Is the great retirement rollover a growth opportunity for ETFs? As retirees have the freedom to move more assets from an employer-sponsored environment to investment accounts, ETFs will likely continue to gain assets from investment advisors who rely on passive investment strategies. The good news is that there’s plenty of room for innovation in the market for retirement ETFs.

— Related on ThinkAdvisor:

• How Much Income Do Retirees Really Need?
• Milevsky’s Bold Plan to Reinvent Retirement Income