Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors have until April 15 to make an IRA contribution for the 2018 tax year. Joining me to share some exchange-traded fund picks for IRAs is Ben Johnson. He is director of global ETF research for Morningstar.
Ben, thank you so much for being here.
Ben Johnson: Thanks for having me, Christine.
Benz: Ben, you brought some ETFs that you think are a good fit for IRAs. First, let's just clear up. Exchange-traded funds--even though some of them are quite tax-efficient, they are not all tax-efficient, right?
Johnson: They are not all tax-efficient, and it depends on what level you are looking at. So, as it pertains to the likelihood that they will distribute taxable capital gains and the magnitude of those gains, they are far more tax-efficient than a conventional mutual fund wrapper. Now, that said, they still throw off regular income not unlike a traditional mutual fund will. So, to that extent, if you are looking at ETFs that are going to throw off above-average levels of income on a regular basis, it might make more sense to park those in a nontaxable account than to have them placed in a taxable setting.
Benz: OK. So, your first idea, and these are all Silver-rated exchange-traded funds, is IUSB. This is a core U.S. bond market fund, maybe a good pick for investors who have taken a step back and looked at their portfolios and said, you know what, I think I probably should add to my fixed-income exposure. Let's talk about this iShares fund and why you and the team like it.
Johnson: Yeah. So, the iShares Core Universal Bond ETF is interesting in that it's kind of an aggregate-plus type approach to building a bond portfolio. So, The Agg tracks investment-grade credits exclusively. The universal index, which is a cousin index, adds an increment of sub-investment-grade credit. So, there's some junk bonds in the mix, there's some dollar-denominated emerging-markets bonds in the mix. And what you see is, by virtue of adding that increment of credit, it better reflects kind of the waters that active managers in the Morningstar intermediate-term bond category are fishing in and becomes a higher hurdle for them. So, it's tough to beat indexing in most corners of the market, especially if the index is more representative of what you can actually invest in, and what I would argue is that the index underpinning IUSB better reflects the opportunity set available to active managers and thus is a higher hurdle for them to beat over the long term.
Benz: OK. But anytime you say some lower-quality corporates and emerging-markets bonds, I think maybe adding to risk. How do you come at that question?
Johnson: Absolutely the case. And adding to risk in much the same way that traditional active managers in this space have been adding to risk by chiefly over the course of the past decade in particular taking on a bit more credit risk. So, it's important to take a step back and frame this in a portfolio setting and say, you know, by adding to risk and, in theory, potentially adding to performance, am I actually just taking on more equity risk in particular? Is this going to be sort of a less good diversifier for my portfolio relative to something that tracks the more ho-hum less credit-risky Bloomberg Barclays Aggregate Index?
Benz: OK. But those stakes are pretty modest in the other categories?
Johnson: Absolutely, really just at the margin.
Benz: OK. So, another idea would be SPDR S&P Dividend, and this is a yield-focused ETF. Let's talk about why something that is paying dividends might make sense in a tax-sheltered account, because investors might say, well, dividends are on par with long-term capital gains right now, why should I take care to shelter such a product inside a tax-sheltered account?
Johnson: Because you don't like paying taxes, I mean, quite frankly. So, if it's going to throw off more income, you don't want to have to necessarily pay taxes on that income at the time it's distributed. Putting it in a nontaxable setting will probably make more sense.
Benz: OK. So, if you are already in distribution mode, you probably don't care. But once you are in an account because you are reinvesting those dividends, you'd like to not pay taxes on that before you have to.
Johnson: So, the first question is, where are you, sort of, on that trajectory? Are you still adding? Are you still accumulating? And if you are de-accumulating, you might be indifferent.
Benz: OK. So, let's talk about this particular product. It's Silver-rated, and it has a bit of a yield focus but doesn't stretch too far in search of yield.
Johnson: Yeah. So, a yield focus with kind of an anchor in stability. So, the index that underpins this particular ETF looks for stocks that have been paying dividends for 20 years consecutively. So, this is an elite group of firms that have made it a policy of regularly returning cash to their shareholders, and many of which have increased that amount of cash that they return to their shareholders in the form of dividends over time. So, it's kind of the top gun of dividend-payers. And then, once it selects from that universe of long-term dividend-payers, it weights them on the basis of their yield. So, it tilts a bit more towards cheaper names, names that for whatever reason at that point at which they are added to the index have been a bit beaten down by the market.
Benz: OK. Let's talk about your last pick. This is VNQ, Vanguard Real Estate ETF. First, let's talk about why tax-sheltered wrapper for real estate securities, and then let's talk about the specific attractions with this fund.
Johnson: Well, much like the first two picks, VNQ is going to throw off a lot of income. It's going to throw off income on a regular basis. So, again, to the extent that you are going to reinvest those income payments that you are in the accumulation stage advancing towards retirement, putting it in a tax-sheltered context makes more sense than owning it in a taxable setting.
Benz: OK. And this is a low-cost ETF, a low-cost ETF focused on the REIT space. Any other things to like about it?
Johnson: Yeah. So, a low-cost leader within the U.S. real estate category, one that recently underwent a bit of a transition. So, it migrated to a new benchmark, a benchmark that is broader than its former benchmark. The new benchmark has got a bigger market cap. It includes some nontraditional real estate securities in the mix. And again, much like IUSB, I would argue, better reflects the opportunity set that's available to all real estate sector investors, and, as such, I think is a better, more-inclusive benchmark for someone who wants just passive indexed exposure to this particular sector.
Benz: Ben, thank you so much for sharing these ideas with us.
Johnson: Thanks for having me, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.