4 ETFs for IRAs

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors have until April 15 to make a contribution to an IRA for the 2018 tax year and they may be mulling what to invest in. Joining me to share three exchange-traded fund ideas for an IRA is Alex Bryan, he is with Morningstar research services.

Alex, your first fund idea, your first exchange-traded fund idea is just to keep things very plain-vanilla to invest in a total stock market index fund like Vanguard Total Stock Market Index. Why do you think it's a good core pick for an IRA?

Alex Bryan: I think this is a great core pick across the board for anyone who wants exposure to U.S. stocks. This particular fund basically owns all U.S. stocks that have decent liquidity, and it weights them based on their market value. Effectively, what this does is it replicates the composition of the U.S. market, effectively harnessing investors' collective wisdom about the relative value of each security.

Now, the market has been very difficult to beat over the very long term. There's a few reasons for that. One, it's very difficult for a lot of active managers to overcome their fees and to earn those back. This particular fund keeps fees low. It keeps fees at 4 basis points, which is $4 for every $10,000 that you invest. That's, I think, the biggest advantage. But this fund is also advantageous because it provides really strong diversification across both individual names as well as sectors. You are not putting all of your eggs in one basket here. I think that's really important, especially if you are an investor who doesn't necessarily have the view on a particular area of the market or a particular stock. This is one way that you can just buy a single fund for your entire exposure to the U.S. market and kind of be done with it.

Benz: Investors sometimes hear "Total Stock Market Index" and think, well, that's a perfect taxable holding. But you are saying it would also work well in an IRA?

Bryan: Yes, absolutely. I think there's a couple of advantages to holding this type of holding in an IRA. One, U.S. stocks right now pay dividends about 2% or so. And if you hold that in a taxable account, you are going to have to pay taxes every time you receive those dividend payments. In a tax-deferred account, you don't have to pay those taxes right away. That's one of the advantages. But more importantly, I think, it's really important to think about the diversification across asset classes. Even though stocks are generally more tax-efficient than bonds, I think it's important for investors who are saving up for retirement to have access to both asset classes, and I think this is a really good way of getting exposure to U.S. stocks.

Benz: Another fund you like is iShares Edge MSCI Minimum Volatility USA. The ticker is USMV. You like the category of minimum volatility funds in general. Let's talk about the thesis there and then this fund in particular.

Bryan: The idea behind minimum volatility strategies is that these are strategies that are designed to reduce the risk of investing in stocks. Now, they still have stocklike risk. They are definitely riskier than bonds are. If the stock market is down, these will also likely lose money. But the idea is that these are designed to provide a smoother ride, so deliver lower volatility than the overall market, provide better downside protection. If the market is down 10%, hopefully, these will be down something less than that, maybe like 7% or 8%. You give up a little bit on the upside. During a strong market rally, these types of funds will tend to lag a bit. But if you are risk-averse and you are OK with that trade-off, I think these are really attractive strategies. They have tended to provide better risk-adjusted performance over the long term. Even though you give up some on the upside, the downside protection more than offsets that. Over the very long term, these types of strategies have provided marketlike returns with lower risk, and I think that's a pretty attractive trade-off that will likely continue going forward.

Benz: You can buy different flavors of these minimum volatility funds. One is like a foreign stock ETF that would target that particular subuniverse?

Brian: That's right. There's various iterations of this strategy, but there is an international version of this. The ticker is EFAV, the iShares Edge MSCI EAFE Minimum Volatility Fund. But this fund, the U.S. version of it, the way that this works is it basically starts with all stocks that are listed in the MSCI USA index and then it uses a pretty complicated algorithm to try to construct the least volatile portfolio possible looking at two things: one, the volatility of individual stocks, and two, the correlations across the stocks. It's trying to not necessarily own the least volatile stocks, but it's looking at stocks that in combination will provide the lowest overall volatility. It's looking at diversification as well as the individual defensive characteristics of each stock.

I think that's an important thing for a core holding because it's not going to load up on just utilities or just consumer defensive stocks. It's still going to own some tech stocks, still going to own some energy stocks. In fact, it actually anchors its sector weightings to that of the broader market, limits itself to within 5%. So, you get a pretty well-diversified portfolio here. But I think this is a portfolio that will provide better downside protection than the overall market, and I think that's really attractive for more risk-averse investors.

Benz: Another fund that is a really interesting idea is Vanguard High Dividend Yield. The ticker is VYM. It's Silver-rated, it's a large-cap value fund. Let's talk about the thesis for holding dividend-payers inside of an IRA, because I think some investors might look at that and say, well, dividends are taxed just like long-term capital gains. So, why should I house a dividend-focused fund inside of an IRA. Let's talk about that to start.

Bryan: When a company pays the dividend, that creates an immediate taxable event. You have to pay taxes on that when you receive the money from …

Benz: If you hold it in a taxable account?

Bryan: If you hold it in a taxable account. So, the benefit of holding this in an IRA or a tax-sheltered account is that you get to defer those taxes, and that allows you to keep more of your money to earn a higher rate of return before you ultimately pay those taxes. I think that's a really attractive place to hold income-producing securities, whether it's bonds or dividend-paying stocks. IRAs are particularly attractive for that.

More broadly, aside from the tax considerations, I think there's a lot to like about dividend-paying companies. One, dividends impose discipline on managers. It prevents them from hoarding cash and makes it harder for them to invest in low-return pet projects and things like that. But also dividends allow investors the fortitude to stay invested through the markets' rough patches. A lot of these companies tend to have a bit more stable cash flows than nondividend-payers out there. Yes, during market downturns, these stocks will go down, but you will still be able to collect the dividend payments. For a lot of investors, that can give them the fortitude to stick with these investments through thick and thin, and it can be easier than holding nondividend-payers.

Benz: A thoughtful group of funds. Thank you so much for being here to discuss them with us.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.