Retirement Income Investing: ETFs vs. Mutual Funds

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 |  Includes: AMJ, BND, BWX, CIU, CORP, CSJ, DEM, DVY, EEM, EMB, FVD, HYG, ICF, IDV, IEF, IEI, IYR, LQD, MBB, MUB, PCY, PEY, PFF, PID, RWX, SDY, SHM, SHY, TIP, TLT, VCLT, VCSH, VEU, VIG, VNQ, VTI, VWO, VYM, WIP
by: MyPlanIQ

High dividend and interest funds are important for retirement investing, especially for retirees. Traditionally, income investors have to utilize income producing dividend mutual funds for income investing purpose. Today, with the explosion of ETF offerings, investors now have many income producing ETFs to choose from. It is thus pertinent to compare investment plans that use ETFs vs. those using mutual funds. In this article, we compare an ETF based income investing plan with a plan using Schwab's income mutual fund select funds.

Schwab's Income Select List was developed and is managed by the Charles Schwab Investment Advisory, Inc. (CSIA) experts and includes mutual funds that have met their rigorous criteria, including both quantitative and qualitative factors. All are no-load and no-transaction fee and are selected based on their ability to generate income in their respective asset classes. The list is designed to help you achieve income and growth. The list is updated quarterly by Schwab. See here for latest update.

We form a plan that uses all of the 37 funds in Schwab's income select list. These funds enable participants to gain exposure to four major assets: U.S. equity, foreign equity, REITs, and fixed income. The following are the funds in the select list:

Asset Class Ticker Name
LARGE GROWTH SWLSX Schwab Large-Cap Growth
LARGE BLEND SWANX Schwab Core Equity Inv
Foreign Large Blend SICNX Schwab International Core Equity Inst
LARGE VALUE TWEIX American Century Equity Income Inv
LARGE BLEND TICRX TIAA-CREF Social Choice Eq Retail
LARGE BLEND PRBLX Parnassus Equity Income - Inv
LARGE VALUE PQIAX Principal Equity Income A
MID-CAP BLEND NMMCX Northern Multi-Manager Mid Cap
Foreign Large Blend LISOX Lazard Intl Strategic Equity Open
LARGE GROWTH JENSX Jensen J
REAL ESTATE CSRSX Cohen & Steers Realty Shares
MID-CAP VALUE ARDEX Aston/River Road Dividend All Cap Val N
Foreign Large Value AAIPX American Beacon Intl Equity Inv
Muni National Interm SWNTX Schwab Tax-Free Bond
Intermediate-Term Bond SWIIX Schwab Premier Income Instl
Intermediate Government SWGSX Schwab GNMA
Muni National Interm TWTIX American Century Interm-T Tx-Fr Bd Inv
Emerging Markets Bond TGINX TCW Emerging Markets Income N
Muni National Interm STTBX RidgeWorth Investment Grade T/E Bond I
High Yield Bond STHTX RidgeWorth High Income I
ULTRASHORT BOND SIGVX RidgeWorth US Gov Sec Ultra-Short Bd I
Intermediate-Term Bond SAMFX RidgeWorth Total Return Bond I
Intermediate-Term Bond PTTDX PIMCO Total Return D
Multisector Bond PONDX PIMCO Income D
Intermediate-Term Bond PGBOX JPMorgan Core Bond A
WORLD BOND PFODX PIMCO Foreign Bond (USD-Hedged) D
Muni National Long NOTEX Northern Tax-Exempt
Intermediate-Term Bond MWTRX Metropolitan West Total Return Bond M
High Yield Bond MWHYX Metropolitan West High Yield Bond M
Intermediate-Term Bond FTRFX Federated Total Return Bond Instl Svc
Short-Term Bond FSTIX Federated Short-Term Income Instl
Muni Short FSHIX Federated Shrt-Interm Dur Muni Instl
SHORT GOVERNMENT FIGTX Federated US Govt 2-5 Yr Instl
Intermediate Government CPTNX American Century Government Bond Inv
Short-Term Bond ACSNX American Century Short Duration Inv
Muni National Long ACLVX American Century Long-Term Tax-Free Inv
Inflation-Protected Bond ACITX American Century Infl-Adj Bond Inv
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In our previous articles, we introduced the Retirement Income ETFs II plan. Similar to the above Schwab's income mutual fund plan, this plan consists of 36 funds. These funds enable participants to gain exposure to five major assets: U.S. equity, foreign equity, emerging market equity, REITs, and fixed income. The following shows the ETFs:

Asset Class Ticker Name
LARGE BLEND VIG Vanguard Dividend Appreciation ETF
LARGE VALUE DVY iShares Dow Jones Select Dividend Index
LARGE VALUE SDY SPDR S&P Dividend
MID-CAP VALUE PEY PowerShares HighYield Dividend Achievers
MISCELLANEOUS SECTOR PFF iShares S&P U.S. Preferred Stock Index
Foreign Large Value PID PowerShares Intl Dividend Achievers
Foreign Large Value IDV iShares Dow Jones Intl Select Div Idx
REAL ESTATE IYR iShares Dow Jones US Real Estate
REAL ESTATE ICF iShares Cohen & Steers Realty Majors
Global Real Estate RWX SPDR DJ Wilshire Intl Real Estate
High Yield Bond HYG iShares iBoxx $ High Yield Corporate Bd
Long-Term Bond LQD iShares iBoxx $ Invest Grade Corp Bond
Long-Term Bond VCLT Vanguard Long-Term Corp Bond Idx ETF
Intermediate-Term Bond CIU iShares Barclays Intermediate Credit Bd
Intermediate-Term Bond CORP PIMCO Investment Grade Corp Bd Index ETF
Short-Term Bond CSJ iShares Barclays 1-3 Year Credit Bond
Short-Term Bond VCSH Vanguard Short-Term Corp Bd Idx ETF
Intermediate Government IEI iShares Barclays 3-7 Year Treasury Bond
LONG GOVERNMENT IEF iShares Barclays 7-10 Year Treasury
SHORT GOVERNMENT SHY iShares Barclays 1-3 Year Treasury Bond
LONG GOVERNMENT TLT iShares Barclays 20+ Year Treas Bond
Inflation-Protected Bond TIP iShares Barclays TIPS Bond
Intermediate-Term Bond MBB iShares Barclays MBS Bond
Muni National Long MUB iShares S&P National Municipal Bond
Muni National Short SHM SPDR Lehman Short Term Municipal Bond
WORLD BOND BWX SPDR Lehman Intl Treasury Bond
Emerging Markets Bond EMB iShares JPMorgan USD Emerg Markets Bond
Emerging Markets Bond PCY PowerShares Emerging Mkts Sovereign Debt
LARGE VALUE VYM Vanguard High Dividend Yield Indx ETF
DIVERSIFIED EMERGING MKTS DEM WisdomTree Emerging Markets Equity Inc
LARGE VALUE FVD First Trust Value Line Dividend Index
WORLD BOND WIP SPDR DB Intl Govt Infl-Protected Bond
REAL ESTATE VNQ Vanguard REIT Index ETF
DIVERSIFIED EMERGING MKTS VWO Vanguard Emerging Markets Stock ETF
Equity Energy AMJ JPMorgan Alerian MLP Index ETN
DIVERSIFIED EMERGING MKTS EEM iShares MSCI Emerging Markets Index
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As of Jun 28, 2011, the Schwab's plan investment choice is rated as above average based on the MyPlanIQ Plan Rating methodology that measures the effectiveness of a plan's available investment funds. It has the following detailed ratings:

Diversification - Rated as great (85%)
Fund Quality - Rated as above average (82%)
Portfolio Building - Rated as above average (82%)
Overall Rating - above average (83%)

Similarly, the Income ETFs II plan investment choice is rated as above average. It has the following detailed ratings:

Diversification - Rated as great (95%)
Fund Quality - Rated as below average (22%)
Portfolio Building - Rated as above average (75%)
Overall Rating - above average (65%)

From the above, we can see the Income ETFs plan offers better diversification but has lower fund quality compared with the Schwab's plan, indicating that the mutual funds still offer better quality through their actively management styles.

We then construct two asset allocation model portfolios from each plan: one is based on strategic asset allocation and the other based on tactical asset allocation strategy. The following shows the portfolios' performance.

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Performance table (as of Jun 28, 2011)

Portfolio Name 1Yr AR 1Yr Sharpe 3Yr AR 3Yr Sharpe 5Yr AR 5Yr Sharpe
Schwab Income Mutual Fund Select List Tactical Asset Allocation Moderate 20% 163% 12% 114% 12% 111%
Schwab Income Mutual Fund Select List Strategic Asset Allocation Moderate 15% 223% 6% 35% 5% 34%
Retirement Income ETFs II Tactical Asset Allocation Moderate 14% 119% 11% 88% 13% 92%
Retirement Income ETFs II Strategic Asset Allocation Moderate 19% 166% 5% 19% 6% 24%
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From the above, one can see both the ETF and Schwab plans offer very similar performance, but the Schwab plan has higher Sharpe ratios. This is due to the more volatile nature of ETFs (due to exchange continuous trading). But on the other hand, ETFs offer flexibility while for Schwab mutual funds one has to obey the 90 day minimum holding periods for those funds (this restriction is observed in the portfolio simulation).

To summarize, income producing ETFs are now able to compete with income producing mutual funds in constructing asset allocation portfolios. This is a significant development for many retirement and income oriented investors.

Disclaimer: MyPlanIQ does not have any business relationship with the company or companies mentioned in this article. It does not set up their retirement plans. The performance data of portfolios mentioned above are obtained through historical simulation and are hypothetical.

Disclosure: I am long IYR, TLT.