If you own a stock and it drops, you have a decision to make. Is this a buying opportunity, or a harbinger of the bad things to come?
But if you own the right ETFs and have a long time horizon, the diversification means every drop is a buying opportunity. No need for analysis, just focus on enjoying your coffee. That is the beautiful thing about ETFs.
With that in mind, we present a three ETF IRA retirement portfolio -- our choices for the three best retirement ETFs for your IRA.
The Three Best Retirement ETFs for Your IRA
1) The Best IRA Asset Class
Equity REITs may be the best class of stock in the market when it comes to generating income for your IRA. Its dividends are not taxed at the corporate level (meaning they are not qualified dividends), so the yields are higher than the market average, and would be taxed more highly were they not in an IRA.
Be Wary Of...
... Mortgage REITs and Business Development Companies. Mortgage REITs trade mortgages and similar securities, and BDCs make loans to businesses. Both sectors offer very high unqualified dividends, but their business models are not necessarily sound.
mREITs mostly borrow money at short term rates and buy longer term securities like mortgages. But with interest rates low and the yield curve pretty flat (meaning less arbitrage between borrowing costs and yield on securities bought) the heyday looks to be over. There are also hedging strategies and concerns like losses on mortgage pre-payment when rates fall and mortgages are refinanced. Essentially you are betting on a team of managers to guess where interest rates are going -- this is not a very sound business model.
BDCs have the unenviable task of lending money in a low rate environment. Any "safe" loan a BDC could make with a decent return is long gone, and the companies are left to finance businesses that are riskier, or have risks that are hard to quantify. It is also hard to know exactly how the end-companies are doing, and if the loans will in fact be repaid.
Compared to Equity REITS and the business model of leasing out property, Mortgage REITs and Business Development Companies don't measure up.
We recently reviewed the best REIT ETFs in the market, settling on three: Vanguard REIT ETF (NYSEARCA:VNQ), iShares Residential Real Estate Capped ETF (NYSEARCA:REZ), and PowerShares KBW Premium Yield Equity REIT ETF (NYSEARCA:KBWY).
The Vanguard fund is large and liquid, and gives you great diversified exposure to the different REIT sub-sectors for a very small fee.
KBW Premium is comprised of micro, small, and mid cap REITs, and compliments the Vanguard fund quite well, which is heavy on the larger names. The smaller REITs likely come with more risk, but this fund is spread out between about 30 stocks, and the yield is just eye-popping.
But our choice is the iShares Residential Real Estate Capped ETF, comprised of residential, healthcare, and self storage REITs. These are some of the best sub-sectors in real estate, and we especially like that the fund avoids retail clients, which could fall prey to Amazon (NASDAQ:AMZN).
Our choice is the iShares Residential Real Estate Capped ETF. Over a long time period an ETF focused on American residential and healthcare real estate may be about as "safe" as an ETF gets, and it throws off cash.
2) The High Yielder
With our REIT fund accounted for, we will turn to the broad market for income. We'll save our growth funds and their low yields for our taxable account -- here we want income.
Watch Out For...
... Corporate debt. Whether it's "investment grade" or "junk", corporate debt has very little upside, is not "safe", and is often not the right choice.
If the debt does not default, then very often it would have been better to be in equities. If the debt does default, then Treasuries would have been a better choice. Holding a mixture of equity and Treasuries -- you get the upside and the safety -- is likely a better long-term strategy than the siren song of high yield corporate debt.
We recently reviewed the best High Yield ETFs in the market, settling on six: the Vanguard High Dividend Yield ETF (NYSEARCA:VYM), the iShares Core High Dividend ETF (NYSEARCA:HDV), the ALPS Sector Dividend Dogs ETF (NYSEARCA:SDOG), the WisdomTree High Dividend Fund (NYSEARCA:DHS), the PowerShares High Yield Equity Dividend Achievers (NYSEARCA:PEY), and the PowerShares S&P 500 High Dividend Low Volatility (NYSEARCA:SPHD).
Each has its merits, but the PowerShares S&P 500 High Dividend Low Volatility fund is our choice for the best High Yield ETF.
This fund is yield-weighted, so the expenses of re-balancing are going to be a little higher than in a market cap-weighted fund (which is self-adjusting). But the yield should be consistently higher than something like the Vanguard High Dividend Yield fund.
That yield-weighting also makes for more turnover, and often means selling out of the best performers in a short time period -- stocks that had a high dividend yield, but rose in price so the yields dropped. That is a recipe for short term capital gains, so this ETF will do much better in an IRA.
The fund also puts caps on individual stocks (3% max) and sectors (25% max), providing structural diversification. It looks like a very good ETF for a retiree's IRA.
3) The Dividend Grower
It's not just income today that we need, but income in the future. So now that we have a high dividend yield fund, let's add a dividend growth fund.
Watch Out For...
... a lot of dividend growth funds. This sector has not been doing its job of growing dividends faster than the market. In the last five years, the S&P 500 (NYSEARCA:SPY) has roughly doubled its dividends, with many dividend growth funds only doing about half of that rate.
These funds are invariably backward-looking, and it may be that the methodology of projecting future dividend growth based on past growth may not work as well as it once did.
The Winning ETF
The SPDR S&P Dividend ETF's (NYSEARCA:SDY) quarterly dividend is only up 21% in the last five years, but the fund has taken to paying a large year end dividend. That brings its five-year dividend growth to over 100%, and based on the last twelve months, this fund is yielding over 5%. That's like owning two ordinary dividend growth funds.
The fund is yield-weighted like the PowerShares fund, not cap-weighted, so the expenses are a little higher vs. the automatically adjusting cap-weighted funds. But the yield is significantly higher than with the other dividend growth funds, and it should consistently be that way.
That yield-weighting also makes for more turnover, and makes for a lot of capital gains. The fund does much more poorly outside of a tax-deferred vehicle like an IRA. But inside an IRA, this looks like the best dividend growth ETF for retirees by a wide margin.
ETFs are a great way to invest without having to worry about the prospects of individual companies, and an IRA is an excellent place to hold income producing ETFs because of the tax deferral.
The iShares Residential Real Estate Capped ETF generates dividends that have not been taxed at all, so they are nice and high. In addition, this REIT's lessors are free from the existential risk of Amazon.
The PowerShares S&P 500 High Dividend Low Volatility ETF provides out-sized yield and structural diversification for a good price.
And the SPDR S&P Dividend ETF has grown its yearly distributions more than two-fold in the last five years, making it one of the only dividend growth funds to perform well lately. In addition, its yield is sky high in the last twelve months. Even if that is something of an aberration, the yield weighting methodology should keep its yield higher than the others in its class.
These are three excellent funds that do very well with the tax protection of an IRA, and these are our choices for the three best retirement ETFs for your IRA.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.