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Investing Insights: Morningstar's Picks for IRAs

Morningstar.com

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Susan Dziubinski: Investors have until April 15 to make an IRA contribution if they want it to count for 2018. Joining me today to discuss three very different investment ideas for an IRA is Christine Benz, Morningstar's director of personal finance.

Christine, it's a pleasure to be here with you.

Christine Benz: Susan, it's great to be here with you.

Dziubinski: Now, your first pick is a fund that focuses on foreign stocks. Why do you think it's important for investors today to be considering this asset class?

Benz: Well, the main thing is that we've seen foreign stocks dramatically underperform U.S. stocks. I know that a lot of U.S. investors are really feeling impatient with their foreign stock holdings. They have seen them underperform for so long. But anytime you see an asset class underperform, that's oftentimes when you should be topping it up, which is why I'm such a big believer in rebalancing, where you restore order to your asset class exposures. Foreign stocks, I think, are a place to look if you are adding new money to your portfolio at this time.

A fund I like for foreign stock exposure is called American Funds International Growth and Income. A lot of investors say, whoa--American Funds, those are load funds, I'm a no-load, do-it-yourself investor. The good news is that they have some terrific funds and they are available on no-load, no-transaction-fee platforms, like Schwab's and other brokerage firms. That's a good development for investors. This is a fund that our analyst team has given a Gold rating because they like its strategy. It's a disciplined value-conscious strategy that focuses on dividend-paying companies overseas. It has a reasonable price tag, and Americans Funds tends to hang on to its managers for many years. There are a lot of things to like about this particular fund. I have made it the core foreign stock holding in my Bucket portfolios, my mutual fund portfolios, and it's also the core foreign stock holding in my Schwab model portfolios.

Dziubinski: Your second idea is a TIPS fund. Now, who are TIPS funds best for? And why are TIPS funds a good fit for an IRA wrapper?

Benz: TIPS are Treasury-Inflation-Protected Securities. These are bonds issued by the U.S. Treasury. But the neat thing about them is that when we see inflation go up, the TIPS holder gets a little bit of an adjustment in his or her principle to account for that inflation. The reason why I would look to TIPS for older adults, in particular people who are getting close to or are in retirement is that when you are retired, and you are not taking a paycheck from an employer anymore, you are not getting those cost of living adjustments. You may be getting them through your Social Security paycheck, but the portfolio of your portfolio that you are withdrawing to live on is not automatically inflation-adjusted. Adding some TIPS to your portfolio can provide that inflation insulation. The fund that our analysts like or one of the funds that our analysts like in this category is called Schwab US TIPS ETF. It's a very low-priced index-tracking product. When our analysts have looked at this TIPS category, that's one conclusion that they have come away with, that active management hasn't really made a good case for itself here, you're better off indexing, keeping things really cheap and getting pure exposure to the asset class.

Dziubinski: Now, your last pick for an IRA may surprise some viewers, particularly since a lot of our viewers tend to be do-it-yourself investors.

Benz: Right. This is Vanguard Target Retirement--name your target retirement date. I like this suite of funds quite a bit because a lot of us use our IRAs to augment our company retirement plan assets. If you are just sort of stashing money in your IRA every year and don't have a lot of time to pay attention to it, if you have a good target-date fund, it can more or less run itself. That's one reason why I like a target-date fund in this context. The other thing to like about the Vanguard suite in particular is that these are very low cost, very minimalist sorts of products. They are composed of index funds. They are globally diversified, so they are quite global for young investors and even for older investors who have heavier fixed-income allocations, they retain a component of foreign bond exposure as well. I think that they are just great set it and don't-pay-a-lot-of-attention-to-it holdings.

Dziubinski: Christine, these are a lot of really thoughtful ideas today. Thank you for sharing them with us.

Benz: Thank you so much, Susan.

Dziubinski: I'm Susan Dziubinski for Morningstar.com. Thank you for watching.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors have until April 15 to fund an IRA for the 2018 tax year. Joining me to share some mutual fund picks is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, you brought a short list of funds that are particularly worthy core holdings that you could hold in an IRA for many, many years. At the top of the list, I think, is a name that will be familiar to many of our Morningstar.com viewers. This is Vanguard Wellington. First, let's talk about its availability. Because people might say, hang on a sec, it appears that this fund is closed. Not so, correct?

Kinnel: That's right. It's closed to outside channels. But if you go through Vanguard, it is still open. So, you can still get in as long as you have an account with Vanguard.

Benz: This is a fund that invests mainly in stocks but also holds some other securities, bonds, and so forth. Let's talk about how it approaches the portfolio. It's an active fund, even though a lot of people associate Vanguard with passive investing.

Kinnel: That's right. Not surprisingly, it's run by Wellington management, and it's about two-thirds equity, one-third fixed income. The equity side has a value tilt. So, there's a bit of an out-of-favor bet there, because value has been out of favor. But I just like it because it's a great core holding. It's super low cost. It's active, but it's priced like it's passive. So, really low cost, which of course, is a great thing for long-term investment. Wellington is a deep team. I feel like it's something you can buy and just keep contributing to and you don't have to do a lot of work to take tabs on what's going on with the fund. It's a pretty dependable fund. I just think it ticks a lot of boxes. Throws off some income, which is not a bad thing to have in a tax-sheltered account. So, really works on a lot of levels.

Benz: Another fund that you like is American Funds Capital Income Builder. This is another one where investors might say, hang on, I'm a do-it-yourself no-load investor, why are you recommending an American Funds. Let's talk about that first--its availability for no-load investors.

Kinnel: That's right. American Funds like most load funds now is available without a load through most of the NTF supermarkets. If you are investing in Schwab or Fidelity or any of the other NTF markets, you should be able to get in. Yes, I'm recommending a load fund, but you don't have to pay the load.

Benz: It's the F share class.

Kinnel: That's right. It's the F share class, which can be a little confusing. But the F share class is still a pretty good value. And again, we've got a really deep team at American Funds. This is, again, another two thirds, one third kind of mix of equities to fixed income. The biggest difference here versus Wellington is the equity side is globally focused. The fixed-income portfolio is still pretty domestic, but the equity side is globally focused. We have an even broader reach for this fund, and again, a really good core holding. Again, it's income-focused. They are looking for income-producing equities and then it's kind of a high-quality fixed-income side. So, again, it throws off a fair amount of income, which I find appealing. And I think just a really nice stable fund--Capital Group really does these sort of income strategies well.

Benz: Right. And the reason that an income strategy might be particularly appropriate for an IRA is that you are not paying taxes on a year-to-year basis on those income distributions.

Kinnel: Exactly.

Benz: Let's look at a pick that is all equity, Dodge & Cox Global Stock, again, with the global emphasis. Let's talk about why this might be an opportune time, especially if you are a long-term investor to top up your non-U.S. holdings.

Kinnel: Foreign equities have underperformed the U.S. for a number of years. And so, if you've been leaving your portfolio alone and haven't really made changes, that means your foreign equity weighting has probably been declining. So, this is a good way to correct for that because it's got a global focus. And Dodge & Cox, I think, is just one of the best organizations out there. They are just very good stewards, low-cost. The analysts and the managers there tend to make a whole career of working at Dodge & Cox, so tremendous stability. A good value strategy. Dodge & Cox, because it's a value strategy they have their ups and downs, but the long-term results are good. They still have really good people there. We also have a lot of confidence in them.

Benz: Russ, thank you so much for being here to share these IRA picks.

Kinnel: You're welcome.

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

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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: Absolutely.

Benz: OK.

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.

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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. With the April 15 deadline to fund a 2018 IRA fast approaching, many investors might be wondering what types of investments they should put inside this wrapper. I'm here with Christine Benz--she is our director of personal finance--with three ideas.

Christine, thanks for joining me.

Christine Benz: Jeremy, it's great to be here.

Glaser: The first category of investments that are good for IRAs are high-dividend-paying stocks. Why is this?

Benz: I think investors might be a little confused by this, but dividends are currently taxed the same as long-term capital gains. You might say, well, why do you make such a big deal about putting the dividend payer inside of an IRA. The key reason is that if you own a dividend-paying company or if you own some sort of a fund that focuses on dividend-paying companies, you get those dividends year in and year out regardless of anything that you might do to try to control the receipt of those distributions. If you do like dividend-paying securities and you have room in your tax-sheltered accounts, I would prioritize them there rather than putting them in a taxable account. Taxable account is great for that plain-vanilla index fund that might happen to have some dividends. But if you are prioritizing a high-dividend-payer, I would house it inside of a tax-deferred account.

Glaser: If you were looking for a dividend fund for this year, what would be a good choice?

Benz: One that our team likes is called Schwab Dividend Equity, the ETF. The ticker is SCHD. This is a fund that is neither extremely high-dividend-focused nor focused exclusively on dividend growth, which tends to lead to a lower dividend payout. It's somewhere in between. It's a very low-cost product. We think it's a really nice option for investors who do want to receive some sort of regular income from their products.

Glaser: The second category to think about are Treasury Inflation-Protected Securities, or TIPS. Why would these be a good choice for an IRA versus other bonds?

Benz: Generally speaking, other bonds are also a good fit for an IRA. Anything that's kicking off high levels of current income in the neighborhood of 3.5%, 4%, that's a security type that you want to think about housing inside some sort of tax-sheltered accounts. TIPS, in particular, I think, are worth a look inside an IRA. For one thing, they tend to not frequently be found on 401(k) menus. This might be a slot that you have open because you are not fulfilling it through your 401(k). The other key reason relates to the taxation of TIPS. When you own a TIPS bond, you own tax on not just the coupon payout but also the inflation adjustment. TIPS are generally a security type that you want to house inside of a tax-sheltered account.

Glaser: Your third category is also in fixed income and that's those higher-yielding bonds will be more aggressive bond funds?

Benz: That's right. The interesting thing is, Jeremy, I was just doing a little prep for a presentation a couple of weeks ago, and I saw that yields have really popped up on some of the lower-quality stuff. I hadn't been paying close attention. But you don't have to stretch for a high-yield bond fund that is yielding 6% today. Same with emerging-markets bonds. We've seen yields pop up quite significantly over the past six months. To the extent that you have some of these higher-income--some of the lower-quality bond types--the yields are significant, especially these days and so, you want to make sure that to the extent that you own them, you are housing them inside a tax-deferred account.

Glaser: If you are looking for a TIPS fund or a higher-yield bond fund, what would be some of your top choices?

Benz: When it comes to TIPS, our analysts have concluded that keeping things really plain-vanilla is a good way to go. They generally find that the index products are very effective and active managers have a hard time adding value.

The funds that I recommend again and again would be Vanguard Short-Term Inflation-Protected Securities. It's one I've got in my model portfolios. Vanguard Inflation-Protected Securities--it has more interest-rate sensitivity, but it's also another good option. In terms of higher-yielding products, one fund I often recommend because it bundles together a lot of different lower-quality fixed-income types is Loomis Sayles Bond. It will hold lower-quality junk bonds. It will hold emerging-markets bonds. It sometimes holds a little bit of equity exposure. It's definitely not for the faint of heart. You'd want to have a nice long holding period for it. But that's a product I like because it keeps you from having to hold a lot of 3% or 4% or 5% positions. It lets you bundle those types together.

Glaser: Christine, thank you.

Benz: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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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.