Ben Johnson's Favorite ETFs for IRAs

This presentation is an excerpt from our Premium-member webinar, Top Ideas for Your IRA.

Christine Benz: Hi, and welcome back. I'm joined here today by 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: Russ just talked about some of his favorite actively managed picks for an IRA. You're going to talk about ETF funds that you like. You divided them in a little different way. You're going to start by talking about some capitalization-weighted funds, so traditional index trackers as well as some strategic beta type products. Let's start with the cap-weighted funds. Vanguard Total World Stock Index, VT is the ticker. That's a world stock fund. It's Silver rated currently. This is a real minimalist pick. If you just want to get it done with a single equity fund, this seems like a good fund to start and end with.

Johnson: This is the ultimate one-stop shop for equity investors. It tracks the FTSE Global All Cap Index. That index is made up of nearly 8,000 different stocks. All the way from $900 billion in market capitalization, Apple, who we all know and love, to $200 million worth of market capitalization for the Thai Food Group. You're talking about a portfolio now of nearly every stock on the planet. It captures 98% of the market capitalization, of the world's public stock markets. It puts a bow around those nearly 8,000 stocks, and it delivers that package to you for a fee of 11 basis points. That's 11 bucks on a $10,000 investment. For one and done, total, global, world equity exposure; there's really no better option than VT.

Benz: That is very cheap as you say, but is there a way to get it done more cheaply, if I were to own discrete foreign stock and U.S. stock index funds?

Johnson: If you were to shop elsewhere, even from just the menu of Vanguard ETF--so pair, say, VTI, which is their Total US Stock Market Index ETF, with VXUS, which is their international stock market ETF--and combine those in a portion that represents the portfolio that you would get with VT, what you would get would be a fee that would be incrementally lower, by about, let's call it, 4 to 5 basis points or so. Which you would assume in that trade-off is sort of the responsibility for ongoing monitoring and maintenance of that, which for many investors might be a perfectly suitable option, because frankly, if you look at the world today, it's roughly 50/50 split between U.S. equities and non-U.S. equities. That might not fit investors' risk appetite, so it's certainly not a fund for everyone. For those who want to set and forget for near forever, and just let the market do the heavy lifting, and pay a very low fee, I think it's a great option.

Benz: I think another thing before we leave this one: Vanguard setup, on its index ETFs is a little different from some other providers in that if you want a traditional index mutual fund, you don't want heavy ETFs, you can do that too, right?

Johnson: That's absolutely the case. Vanguard has a novel structure that's protected actually, by patent, whereby their ETFs are simply just a separate share class of their mutual funds. That has certain benefits. It lends them the benefit of scale, of having a broader pool of assets. That allows them in many cases to drive costs lower for investors. Vanguard investors have the option of looking at the ETF share class, which I think is most suitable for those investors that have smaller amounts to invest, that might not be able to access the admiral share, which requires a $10,000 minimum investment. They'll get better than investor share pricing via the ETF pricing that's at parity with the admiral share; but if you can afford the admiral share, and you simply don't want to have to deal with the transaction costs and all of the ins and outs of trading ETFs, the admiral share class of the index mutual fund is a perfectly suitable option. It may be a superior option for people who just aren't comfortable with navigating the ins and outs of ETF trading.

Benz: Good to know. The next pick, this is, I would say, not such a core pick. This is a capitalization-weighted fund. This is iShares Core MSCI Emerging Markets, ticker IEMG. It's Bronze rated. Let's talk about why you and the team like it.

Johnson: We like this chiefly because it's a market-capitalization-weighted strategy. When you're buying a broad-based market cap weighted index, you're effectively free riding on the collective decisions of active managers, of buyers and sellers of stock to set roughly the right prices over a long period of time, which allows for very low turnover, which is a feature of this fund, and a very low fee. At 14 basis points, it's extremely competitive relative to its peers in its category.

Benz: Follow up question. If you like this fund, or you're looking at this fund, you'd better like China, right?

Johnson: You had better like China. Chinese stocks, which fall under various definitions, make up nearly 30% of this fund's portfolio as it stands today. What I would stress there is that again, this reflects the opportunity set that's available to investors in emerging markets. China's rise to prominence in this particular index, especially very recently, has been driven by a surge in the technology sector, which has been spearheaded by a pair of tech giants, Tencent and Alibaba, which together comprise a pretty substantial piece of this index portfolio. It's important to peel back the label on the tin and understand both the country and the individual security level exposures that you're assuming in this fund. Decide whether or not you're comfortable with the risks that are associated with that, which have to do with doing business in China, the specifics of the tech sector, and there's an element of currency risk that's important to understand when it comes to investing in emerging markets as well.

Benz: Those are more or less vanilla capitalization-weighted products. You also brought some strategic beta funds that put some spin on the ball, rather than investing in a cap-weighted index. Let's start with the first. It's Vanguard International High Dividend Yield Index, VYMI is the ticker. It lands in the foreign large-cap value category. It has a pretty nice yield of 3%. We have it rated as Bronze. Why do you and the team like this one?

Johnson: We like it's very simple and elegant approach to constructing a portfolio of international stocks that pay above average yields. It starts with the universe of stocks that reside outside the US. It looks at those that are expected to have the highest yields over the next 12 months, and adds those to the portfolio until it winds up with about 50% of the market cap of the beginning universe. Now, what that does is it mitigates some of the risk that's associated with just investing in higher yielding stocks. They have higher yields for a reason, which may be that they're inherently more risky, that they're going through a rough patch. Investors are probably selling these stocks recently, for one reason or another.

Now, by anchoring on market cap, what it does is it pulls the portfolio toward the largest names in that universe; these are more stable firms. They are firms that tend to have either wide economic or narrow economic moats, in Morningstar parlance, which means that in all likelihood their dividends are more defensible. It also owns a large number of securities, especially relative to some other strategies that try to achieve a similar objective, which can hide some of the errors. Some of the issues that might crop up, when one or two or three of the stocks included in that portfolio prove to be sporting high yields for a very good reason, because they are indeed distressed.

Benz: Your next strategic beta pick is iShares Edge MSCI Minimum Volatility. The ticker is USMV. Before we get into this particular fund, can you state what you think are the main advantages of a low volatility strategy? Why you might even want to approach the market in this fashion?

Johnson: I think at this particular point in the market cycle, probably the key advantage of a low volatility strategy would be behavioral, to maintain equity exposure and maintain a type of equity exposure that you would be more likely to stick with. I say more likely to stick with in that the low volatility products that are out there, and USMV in particular, has shown over its track record--which has not, I should point out, included a bear market, but a number of pronounced drawdowns--to have much lower standard deviations, so just general volatility, relative to the market. Much less sensitivity as measured by its beta to the market. It's beta to the S&P 500 has been 0.67 over the past three years, which means anytime the S&P has moved 1%, it's gone up 0.67%. It's had relatively muted drawdowns as well. Those relatively muted drawdowns, I think, are a key feature that might help investors stick with this particular fund and stick with just U.S. equity strategy should we go through another bear market.

Benz: That's an important advantage, keeping people in their seats. Let's turn to your last idea for IRA contributors. This is Schwab US Dividend Equity. The ticker is SCHD. This lands in the large-cap value category. It has a decent yield, and one thing that I've often thought about, you talk about these yield focused ETFs either being payers, or yielders, or growers. Where does this one land?

Johnson: SCHD is interesting, because it tries to kind of combine the best of both worlds. It starts with a subset of stocks that have paid dividends for 10 years, so there's an element of sustainability and growth that's infused in this index methodology at the onset. It then looks at the highest yielding half of that first cut, so income is a bit of a yield orientation, a bit of a value orientation. It then looks at that subsequent cut, and screens on the basis of different fundamental metrics to understand whether or not these dividend payments are indeed sustainable, whether or not they will grow. It's kind of a cocktail of both yielder and grower.

What you've seen and what comes out in the wash is a fairly concentrated portfolio. It holds around 150 stocks, of very high quality firms that have indeed grown their dividends over time, and in all likelihood will continue to do so over time, but might be relatively depressed with respect to their valuation. You're not going to get a huge value kicker here, but there's a whiff of that in the mix as well.

Benz: Ben, thank you so much for being here to share your picks. It's always great to hear your insights.

Johnson: Thanks for having me.

Benz: Join us here in a few moments. We'll be bringing back Sarah Bush. She will be sharing some bond fund picks to consider for your IRA. Just sit tight for just a couple of moments. Thank you.