Who Needs Bonds? ETF Alternatives for Your Retirement Portfolio
As the ETF industry continues to grow, more and more investors are embracing the exchange traded-product wrapper. From individual to institutional investors, and even 401(k) plans, ETF usage has skyrocketed exponentially as more are drawn to the structure’s transparency, low-cost, and efficiency. Though the majority of ETF trading is done by institutional players, the industry has seen an uptick in individuals using these products to build core buy-and-hold retirement portfolios [see Owning the Market Isn't As Easy as it Sounds].
For those investors nearing retirement, fixed income ETFs are a natural choice. But with interest rates expected to remain near zero for some time yet, bonds may not be the best fit for everyone. In this piece, we go beyond the typical bond ETFs, and highlight ETF alternatives for your retirement portfolio.
Over the years, yield-hungry investors have taken to equity markets for juicier sources of income. In the world of exchange-traded products, dividend ETFs have become even more popular in recent years, thanks to their low costs, transparency, and wide array of dividend-focused strategies.
Typically, these funds are comprised of some of the largest, oldest, and well-known names on Wall Street. These companies–often categorized as large-cap value firms–are considered to be the most stable corner of the equity market. Furthermore, dividend-paying stocks allow investors to profit from capital appreciation in addition to providing a steady income stream.
It should be noted that not all dividend ETFs are appropriate for all kinds of retirement portfolios. If you are nearing retirement, funds that invest in consistent dividend payers will be a safer bet because companies that have paid cash distribution for multiple years are more likely to continue doing so in the future. Some of the most popular funds that focus on consistency are:
- Dividend Appreciation ETF (VIG): This fund invests only in companies that have a history of increasing dividends for at least 10 consecutive years.
- SPDR S&P Dividend ETF (SDY): This ETF tracks an index that is comprised of the 50 highest dividend yielding constituents of the stocks of the S&P Composite 1500 Index that have increased dividends every year for at least 25 consecutive years.
- Morningstar Dividend Leaders Index Fund (FDL): This fund invests in companies that have shown dividend consistency and dividend sustainability.
Another corner of the dividend space that may be appealing for a retirement portfolio is in utility equities. Historically, utilities have exhibited relatively low volatility compared to the broader market, and are therefore embraced for both buy-and-hold prospects as well as a defensive strategy. In addition, these stocks typically offer attractive high yields; on average, utilities yield roughly 4%.
Preferred Stock ETFs
A preferred share is like a hybrid between a common stock and a bond. When you buy preferred shares, you own a piece of the company and in exchange receive fixed dividend payments, which are set at issuance, along with the par value of the preferred stock [see 3 Things You Need to Know About Preferred Stock ETFs].
Investors who have lower risk tolerances may find preferred stocks to be ideal because of their bond-like structure. In addition, preferred shares typically have a low correlation with bonds and stocks, making them great diversifying agents. These securities are also less volatile than common stocks, but slightly more risky than bonds.
There are only a handful of Preferred Stock ETFs for investors to choose from, including:
- S&P US Preferred Stock Index Fund (PFF)
- SPDR Barclays Capital Convertible Bond ETF (CWB)
- Financial Preferred Portfolio (PGF)
- Market Vectors Preferred Securities ex Financials ETF (PFXF)
Investors should note that interest rates are important to keep track of, as rates have an inverse effect on the price of preferred shares. Since the dividend payment on preferred shares is fixed, the price of the security will fall if interest rises so that the new yield on the security is market competitive; similarly, when interest rates fall, the price will rise.
The buy/write strategy has been around for decades, and is popular for investors looking to mitigate risk in equity markets. At its very basic, a buy-write or covered call is an investment approach where the investor buys a stock or a basket of stocks tied to an index and writes call options that cover the stock position. A call option gives its holder the right to buy a stock from the option seller at a certain price by a certain date.
By writing the call, an investor caps the upside potential of the underlying stock. Moreover, if markets sink this strategy provides some down side protection, as the premiums received serve to offset some losses. The downside in this strategy comes if markets rally; the position as a writer of call options means that gains will be limited if the underlying index surges higher.
The three most popular ETFs employing this strategy are:
The Bottom Line
Though most near-retirement portfolios focus mainly on fixed income exposure, investors should consider alternatives like dividend, utilities, preferred stock, and covered call ETFs. Not only do these funds add a layer of diversification benefits, but they also provide investors with opportunities to enhance current income, mitigate risk, and generate capital appreciation.
Follow me on Twitter @DPylypczak
Disclosure: No positions at time of writing.