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2 ETFs for an IRA

Ben Johnson examines what type of ETF is best suited for this wrapper.

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Christine Benz: Hi, I'm Christine Benz for Morningstar. Its IRA season, and many investors may be looking for investments to park in their accounts. Joining me to share some ETF ideas is Ben Johnson. He's Morningstar's director of global ETF research.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: So, Ben, investors often think of ETFs as a good choice for their taxable accounts. In a lot of ways, they are. But they can also make sense for their tax-sheltered accounts because there are some investment types that kick off income distributions, and it doesn't matter what sort of wrapper you have the investment in--the taxes are what they are.

Johnson: That's exactly right, Christine. So, I think the first place where investors should consider parking ETFs is within their taxable accounts for all the reasons you've described. ETFs have a structural advantage over traditional mutual funds that helps them to reduce the tax burden specifically as it pertains to capital gains distributions, which tend to be few and far between in the land of ETFs. Now that said, no different than any other fund, ETFs are going to pay out regular income; they're going to pay out regular dividends. So, when I looked in our database to understand which ETFs might be better candidates for IRAs, I focus specifically on income and sorted them by their 12-month yields. I also obviously want to look for quality funds, for obvious reasons.

Benz: Right.

Johnson: People want good funds. So, the pair that that I found that I think would be good candidates for positioning in an IRA are both equity strategies. It's a pair of sort of related Vanguard ETFs. So, the Vanguard High Dividend Yield ETF and then it's international sibling, the Vanguard International High Dividend Yield ETF. So these both throw off, as their name would imply, quite a bit of income. They track indexes that look at their investable opportunity set, and they rank order the stocks there based on what their expected yields are over the course of the next 12 months. And then they start to fill up that portfolio until they've got stocks that represent half of the investable market cap either in the U.S. or outside the U.S.

So, they take those stocks then and weight them by their market cap. That weighting schema helps to address some of the issues that you might face when you select stocks weighted by yield, which puts you at risk of catching some riskier names. So, it pulls the portfolio towards larger-cap stocks. Their dividends tend to be a bit more durable. It results in a bit of a quality tilt. These are portfolios that are delivered at a very low cost. They're managed by a great very experienced team in Vanguard's Equity Index group and backed by Vanguard. So, a pair of funds that I think, on the basis of throwing off fairly sizable, fairly regular dividend payments, are interesting candidates for people looking to shelter those dividends from Uncle Sam in the confines of an IRA.

Benz: And it seems like they could also have some use in the context of older adults who are subject to required minimum distributions, where they have to take money out of their IRAs, and you have to source those cash flows from somewhere. It seems like to the extent that these investments are kicking off income, they could work well in that context as well.

Johnson: That's absolutely right. So, to be able to not dip into capital, not dip into principle and just simply allocate those regular payments to an RMD bucket within that IRA--that's absolutely a terrific use case.

Benz: So just a question about the international one, because I think people might be really attracted to its dividend. It's higher than the U.S. funds, correct?

Johnson: That's right.

Benz: So, let's just talk about kind of right-sizing that position--that you wouldn't necessarily want to use that as an extremely large position within your portfolio. Would you?

Johnson: I think it depends on the investor in question. So, if you just look at the global market more broadly, the split in terms of the market-cap-weighted global market is roughly half and half between U.S. and ex-U.S. Now, that said, many investors have demonstrated--in many cases rightfully so--a degree of home bias. So most investors are going to tend to favor U.S. stocks over international ones for a variety of reasons. That's not necessarily right nor wrong. It really depends on the context. Certainly, the temptation might be to tilt, and certainly I think there's room to tilt further in favor of international stocks over U.S. ones, given that existing bias and given that both yields and, more generally speaking, valuations outside the U.S. look somewhat more compelling today than they do within the U.S.

Benz: You do have some foreign-currency risk, though, right?

Johnson: There is also foreign-currency risk to take into account, which is absolutely right. To the extent that this is a global portfolio in VYMI, there's a bit of kind of in-built diversification to the extent that the portfolio represents a variety of different stocks across a variety of different currencies. And then there's the added element of the currency exposure of those underlying stocks as well. So, currency risk is present. It is not a risk I would expect to pay off over a long period of time, but it's certainly one to be cognizant of.

Benz: Ben, thank you so much for being here to share two IRA picks.

Johnson: Thank you.

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

Ben Johnson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.