A Conservative ETF Portfolio for Retirees

"I liked your retirement portfolios, but wish you had included some ideas for us exchange-traded fund investors."

This and other e-mails like it began hitting my inbox shortly after the publication of my model portfolios for retirees, which featured model retiree portfolios composed of traditional mutual funds.

It's a great question, because ETFs have many features that make them ideal for retirement savers. Many ETFs have nice, low costs--a particularly important attribute for investors who are devoting a sizable share of their portfolios to cash and fixed-income investments. Given that these asset classes' long-term absolute returns may be lower than stocks', keeping expenses down can significantly improve your take-home return.

And though transaction costs can be an Achilles' heel for active ETF traders, as you may pay commissions to buy and sell your shares, they're apt to be less of an issue for retirees. That's because many retirees are investing large sums all at once--via company retirement-plan rollovers--and don't plan to make substantial additional contributions to their accounts. Of course, retirees may pay commissions when they need to sell shares to cover living expenses, but many of the major brokerages are offering commission-free ETF trades on many funds in their lineups. In short, the total costs associated with building and holding an all-ETF portfolio may still be lower than maintaining a portfolio consisting of conventional no-load mutual funds.

There's also performance to consider; while some active fund managers have done a superb job of limiting downside volatility over time, active funds in aggregate haven't made a compelling case for themselves, particularly on a risk-adjusted basis. (That doesn't mean that it's impossible to pick active funds that can outperform, however, as our Analyst Picks' batting average shows.)

Morningstar research also indicates that ETFs have the edge over traditional mutual funds when it comes to tax efficiency. Of course, there's no avoiding taxes if you pocket an income or dividend distribution from an investment, whether it's from an ETF or some other vehicle. But for those who are holding ETFs inside taxable accounts, our analysis of the data indicates that ETFs have done a very good job of limiting taxable capital gains--a better job, in fact, than conventional index mutual funds, which are quite tax-efficient in and of themselves.

Finally, because retirees are interested in many other activities besides overseeing their portfolios, ETFs' ease of use is a huge benefit. Nearly all ETFs track market benchmarks, so it's easy to assemble a portfolio that precisely matches your target asset allocation and to rebalance it when it gets off track. Without active managers in the mix, you won't have to worry about issues like management changes or the chance that an active bet will skew your portfolio in one direction or another. You can also readily assemble a well-diversified portfolio with very few individual ETFs--a key advantage if you're looking to reduce your portfolio-monitoring time as well as the amount of paperwork flowing into your house.

With all of those benefits in mind, we put together some ETF-focused model portfolios for retirees and pre-retirees. Today's article showcases the conservative version. It's appropriate for very risk-conscious retirees with a time horizon (estimated life expectancy) of 10-15 years. Thus, stability and preserving purchasing power are key goals for this portfolio. (Please see our related model portfolios for moderate and aggressive ETF investors, as well.)

In-Retirement Portfolio: Conservative

Holding

Allocation %

Vanguard Mega Cap 300 Index

13

Vanguard Mid Cap ETF VO

4

Vanguard Small Cap ETF VB

2

iShares MSCI EAFE Index EFA

5

Vanguard Emerging Markets Stock ETF VWO

1

iShares Barclays TIPS Bond TIP

25

Vanguard Short-Term Bond ETF BSV

13

SPDR DB Int'l Gov't Infl-Protected Bond WIP

4

iShares Barclays MBS Bond MBB

10

iShares iBoxx $ Inv Grade Corp Bond LQD

16

Cash

7

Total

100

To provide an asset-allocation blueprint, I've used Morningstar's Lifetime Allocation Indexes, which in turn rely on the research of Ibbotson Associates, a division of Morningstar. Users should feel free to tweak these allocations based on their own situations, risk tolerances, and time horizons, but my hope is that these portfolios and their allocations will provide valuable food for thought.

To help identify the best ETF investments to populate these portfolios, I've leaned heavily on the insights of Morningstar's exchange-traded fund team, led by Scott Burns. That team produces Morningstar's ETFInvestor newsletter, which also includes two model portfolios--the Hands-Free Portfolio, a long-term strategic portfolio, and the Hands-On Portfolio, featuring a more tactical-allocation approach. Note that these portfolios include holdings from multiple providers such as Vanguard and iShares, but it's possible to get fairly close to these portfolios' asset allocations using a single provider.

A Total Return Approach This conservative portfolio stakes less than 25% of its assets in stocks and holds the rest in a combination of cash, Treasury Inflation-Protected Securities, and other bonds.

Yet even though it's heavy on fixed income, this portfolio employs a total-return approach rather than one that's focused on generating current income. With yields as low as they are now, for both stocks and bonds, I think it's impractical to expect that your portfolio can generate a livable level of income without taking outsized risks.

In assembling the portfolio's core fixed-income positions, I followed the thinking of Morningstar's exchange-traded fund team. Instead of a total bond fund, these portfolios include two intermediate-term bond offerings:

LQD and iShares Barclays MBS Bond MBB. Together, these two funds replicate the securities in a total market bond index fund, except they exclude the government-bond exposure. (Those seeking a more streamlined, hands-off portfolio that's agnostic about the current market environment could also use a total bond market index fund like

BND; because of their high exposure to government bonds, such funds held up extremely well amid the recent stock-market volatility.) However, it's worth noting that the portfolios don't eschew government bonds altogether. In addition to the aforementioned TIPS position, they include positions in

BSV, which stakes about 60% of its assets in bonds issued by the U.S. government and its agencies. Those bonds would give the portfolios ballast in an extreme flight to quality like that in 2008.

Although inflation is currently well under control, preserving purchasing power should be a key goal for any long-term portfolio anchored in fixed-income securities. For that reason, this one holds close to 30% of its assets in ETFs with explicit inflation-fighting tendencies. Its core inflation-fighter is

TIP, which provides inexpensive, plain-vanilla exposure to TIPS. (Given the size of that position, as well as the fact that TIPS aren't particularly cheap at this juncture, my advice would be to slowly build a TIPS position during a period of 12-18 months rather than adding it all in one go.)

The portfolio also includes a smaller position in

WIP, giving it exposure to inflation-protected bonds issued by foreign governments. As with TIPS, the foreign inflation-protected bonds' principal values adjust upward to keep pace with inflation in the country in which they're issued. That can provide a valuable hedge in a period of rising global prices, but it also introduces some currency-related risk, as these bonds are denominated in foreign currencies. For that reason, I've kept it to a small position here. Inflation-conscious investors might also consider a small slice of commodities or even precious metals exposure, but they should bear in mind that these funds can be extraordinarily volatile on a stand-alone basis.

On the U.S. equity side, I've again modeled the holdings on

ETFInvestor

's Hands-Free Portfolio and have included three distinct funds:

MGC,

VO, and

VB. Holding the three separate funds gives an investor the flexibility to adjust the portfolio's weightings in each of these holdings as needed--for example, all of these portfolios have a slight emphasis on mega-caps versus the broad market. However, one could obtain similar market exposure via a broad market index portfolio such as

VTI. Alternatively, a more conservative investor might invest the bulk of his or her domestic-equity assets in a fund like

VIG, which focuses on relatively stable companies with a history of increasing their dividends.

The Role of Cash As with the portfolios composed of traditional mutual funds, you'll notice that the portfolios I've included here have very limited cash holdings. Morningstar's Lifetime Allocation Indexes include cash only insofar as it improves the portfolio's overall risk/return characteristics, not for liquidity purposes. The amount of cash you hold will be highly dependent on your personal situation: your spending needs, whether you're receiving income from other sources, and the size of your overall portfolio.

The conventional rule of thumb is that retirees should hold two to five years' worth of living expenses in cash. But with cash yields as low as they are right now, I think it makes sense to keep cash at the low end of this range and then invest any additional monies you expect to be tapping in the two- to five-year time frame in a high-quality short-term bond fund such as Vanguard Short-Term Bond.