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IRA Rollover Boom Spells Opportunity for ETFs: Finke

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Rates of growth in exchange-traded funds, or ETFs, have trounced the growth of mutual fund assets over the last decade. Except for retirement. Mutual funds remain the dominant investment within defined contribution savings plans.

Yet 2015 marked the first year in which retirees began pulling more money out of 401(k)s than they invested. This great American pullout isn’t going away as the boomer wave drives rollovers into IRAs and ultimately withdraws required minimum distributions (RMDs).

Is this the moment where retirement ETFs can start making a comeback? The short answer is that ETFs provide modest advantages over mutual funds in IRAs, but they could provide significant advantages in taxable accounts once the government starts forcing boomers to start taking RMD checks. ETFs might also benefit from the continuing movement toward automated, passive investments by American workers.

Let’s review what ETFs are. In order to create an ETF, an investment company buys assets like stocks, bonds, real estate or commodities, and issues shares of the fund to investors. An investor owns a theoretical slice of the aggregate portfolio of assets. Shares of ETFs trade on an exchange just like stocks, and any income or capital gains earned by the ETF are passed to investors and taxed just like direct investments in that asset. Generally ETFs are considered more tax efficient than mutual funds because mutual funds incur more frequent short-term capital gains when fund managers sell assets to meet redemptions.

So why have ETFs lost the defined contribution battle? According to Hollie Fagan, head of BlackRock’s dedicated Registered Investment Advisor Consultant Team, “the mechanics of a 401(k) make it more difficult to allow ETFs into a plan as an investment option versus a mutual fund. There are a lot of issues structurally that have made it difficult for plan sponsors to add ETFs as an investment choice.”

Defined contribution plans continue to support a mutual fund industry that has consistently lost ground to ETFs outside of employer-sponsored plans. Since 2000, the rate of growth in ETF assets has consistently outpaced mutual funds. Assets poured into ETFs during the 2000s and inflows continue to favor ETFs over traditional mutual funds. Despite a higher rate of growth, however, investments in ETFs were still only 12% of mutual fund assets in 2014.

Efficiency Gains

The trillions of dollars in employer plans won’t stay there forever. Each year, hundreds of billions will make their way into investment accounts in which ETF strategies are becoming mainstream.

Despite marginal advantages over the best passive index mutual funds, ETFs are a generally more efficient fund structure that allows investors to trade during the day and avoid some of the expense drag. In addition, ETFs are the preferred investment of advisors using contemporary wealth management tactics that focus on creating a core of passively managed assets and an overlay of alpha-seeking strategies.

Fagan sees an emerging trend among investment advisors who rely heavily on ETFs when building client portfolios. “If you look at the industry flows in the past three or five years, you see the increasing use of a barbell type of approach in which investors and financial advisors are no longer willing to pay high fees for beta returns.”

Instead, advisors view market returns as a commodity, and ETFs are the most efficient way to gain access to broad financial indexes. “People have a risk budget, and they have a fee budget,” notes Fagan. “When they’re constructing a portfolio, they’re no longer willing to use the fee budget and the risk budget on closet indexers.”

While ETFs dominate on one end of the barbell, at the other end are investments held specifically to improve the risk/return characteristics of the portfolio. These may include more active strategies by managers who are less constrained by traditional style boxes in order to provide an edge over passive market strategies. A barbell provides the highest risk-adjusted return from both active and passive strategies, and the passive money is held in ETFs.

Asset Location

In addition to asset allocation strategies, ETFs can be useful in locating investments within taxable and tax-sheltered accounts. In general, higher-yield corporate bond ETFs are tax disadvantaged and well suited to IRA accounts. In taxable investments, ETFs are less likely to incur short-term capital gains taxes of up to 43.4% than mutual funds — particularly mutual funds that have higher turnover.

“In a taxable account, the advantage of an ETF would be its low cost,” Fagan points out. “If you look at the S&P 500, the iShares S&P is 1/6th the cost of the average style box mutual fund. If you look at that same fund, it has outperformed 87% of actively managed mutual funds over the past 10 years.”

The benefit of ETFs over mutual funds in taxable accounts may be somewhat overstated, mainly because passive index mutual funds have low turnover and create few short-term capital gains. According the David Blanchett, head of retirement research at Morningstar, “ETFs obviously cost less than all mutual funds (viewed collectively), but that’s more of a comparison of active/passive than passive/passive. When doing the passive/passive comparison (index mutual funds versus ETFs), there really isn’t much difference.”

On the aggregate, however, ETFs provide a tax efficient diversified portfolio in taxable accounts that can serve as the core risky investment allocation within a retiree’s portfolio. If you want to maintain a 50/50 portfolio, invest in equity ETFs within taxable accounts and bond funds and alpha-seeking, higher turnover investments in tax-sheltered accounts.

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.

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