Equities and Exchange Traded Funds (ETFs)

Exchange Traded Funds (ETFs) are becoming an increasingly popular investment used by Australians planning their retirement.  This market segment has grown from $36.3 billion in 2018 to $45.8 billion in 2019.

For many investors, ETFs have a lot of attractive features – perhaps most important being a high degree of diversification at low cost.

In 2016, Exchange Traded Funds were used as “a potential solution” for the challenges of retirement planning.  The use of ETFs for retirement planning was discussed during the S&P DJI 10th Annual Australian Indexing & ETF Masterclass which considered a variety of benefits such as accessibility and cost and transparency.

For example, if an investor wanted to get exposure in the Technology sector but had limited funds of $50,000, normally they would have to pick 2 or 3 Tech stocks such as Apple, Microsoft or Samsung and spread their $50,000 across the 3 funds and hope they perform well.

The problem with that investment strategy is if one stock performs well, the second breaks even and the third stock drops by 10% then the investors well-performing stock is dragged down by the two other stocks that didn’t perform well so after 1 year the investor either broke even or ended with a slight loss.

But if the investor used the same $50,000 and purchased a Technology based ETF, then the $50,000 is now spread across 20 or more Tech companies which means the investor can now benefit from more well-performing technology companies because there is more diversification.

It’s almost like backing 10 horses in the race all to Win instead of backing 3 out of the 10 horses in the same race.

Why ETFs are a good investment

As Australians reach retirement, capital preservation and diversification becomes increasingly more important as individuals seek to ensure they have sufficient funds for retirement. ETFs offer retirees a means to diversify their risk instead of being fully exposed and vulnerable to market downturns which can disproportionately impact retirees because they have less time to recover from these inevitable market downturns and more importantly, they need every bit of that money to continue providing an income stream.

There are three types of ETF’s which are listed below:

Passive

Passive ETFs aim to track an index and generally don’t try to outperform it

Active

Active ETFs buy and sell investments based on an active strategy and they attempt to outperform a certain benchmark

Synthetic

Synthetic ETFs generally hold all or a representative sample, of the assets of the benchmark they seek to track

However, where an asset class may be difficult to physically hold, some ETF issuers synthetically replicate the performance of the assets they seek to track.

Liquidity

ETFs are highly liquid and can be bought and sold on the ASX just like ordinary shares, so unlike a managed fund which is made up of units and thousands of other investors, as long as there is market depth and demand for the ETF you can buy and sell it on the same day and cash in within 5 days or less.

During the COVID-19 Pandemic it was taking some fixed interest cash funds up to 3 weeks to sell down the units of a fund.  This would not be the case with a liquid ETF as long as there is market depth and trading volume on that ETF.

Lower fees

Fees for ETFs are lower than typical funds and this can be by as much as 1%.   When we compared a Technology fund to a Technology ETF the difference in fees was 1.37% for the fund verses 0.48% for the ETF.  Add that up over time and it can be tens-of-thousands of lost dollars over the years.

Advantages of ETF Investment for Retirement

ETFs enable broad exposure across markets and asset classes. They provide a means of access which may not otherwise be available, increasing a retiree’s diversification.

Retirees need to mitigate their exposure to market falls by implementing a mix of strategies. Diversification with ETFs can be achieved using what we call “the core satellite approach”.

For instance, if retirees allocate 50% of their money in a passive ETF option and the balance across more active strategies, then they will have achieved a good mix.  This will ensure that if the market falls, then all their investment is not tied to the decline.

Another option is where retirees may also look to diversify their market exposure by investing in ETFs across asset classes.  This can reduce growth, but this is generally less important for retirees who seek protection from market volatility.

Tax efficiency

Retirees are likely to hold their investments for longer than 12 months as they are no longer in the growth stage of investment. After this time period, investments such as shares held in ETFs are eligible for capital gains discounts.

Additionally, investors may receive franking credits and foreign tax offsets using ETFs. Investors can either offset their tax liability on dividends by paying the difference between the company tax rate and their marginal tax rate or claim back the tax in their tax return.

If the accumulation part of retirement planning is successful, portfolios will often be at their largest around retirement and therefore ensuring tax-effective management at retirement is vital.

Disadvantages of ETF investment for retirement

Despite the proliferation of ETFs, some investors will find them inappropriate for various reasons such as tax treatment, exposure, or Environmental, social and governance (ESG) issues.

Disadvantages of ETF use by retirees may include:

Market risk – Despite the option of minimum-volatility ETFs and diversification, ETFs are still vulnerable in a falling market. Due to sequencing risk, early-stage retirees who use them risk being locked into an index in a bear market

ETF solutions to retirement planning

Investors favoring active strategies highlight the risk that index funds “capture 100% of every market downturn” and that means it could be more difficult to sell out of passive positions in certain circumstances.

For retirees, who have a limited time for the market to recover, this poses a significant threat to their income and savings strategy.

Liquidity drawbacks

Although ETFs are considered liquid investments, options such as an open-ended mutual funds can be seen to fulfil the same purpose without investors having to pay the same level of spreads coming into an ETF. However, the market regulator (ASIC) provides guidelines about using independent third-party market makers to provide tight bidoffer spreads attempt to mitigate this.

Additionally, with the susceptibility of ETFs to market fluctuations, extracting funds becomes disadvantageous during periods of volatility. As with market risk, this can make ETFs riskier for retiree and pre-retiree investors.

Tracking performance

ETFs are fundamentally designed to track an index however there is a risk that the return on the instrument may deviate from the index or benchmark being tracked.

This may be because of fees, unexpected expenses or, in some cases, an intentional departure by the manager to seek higher returns.  This deviation may result in retirees receiving lower returns than they were relying on as part of their retirement plan.

Over reliance on low cost

It has been found that a significant proportion of low-fee retirement solutions do not consider client’s individual circumstances such as income and other investments.  Asset allocation remains vital and an awareness of a client’s individual circumstances such as life expectancy cannot be overlooked.  Without this, lower cost investments can result in too little or too much risk being taken.

Tax complexity

Classified as trusts rather than ordinary company shares, taxation treatment of ETFs can make them a more complex investment option. If retirees require more assistance managing their tax situation, professional fees will eat into their returns, potentially reducing the advantages of ETFs.

Some ETF’s provide quarterly distributions and simple statements, followed by a final detailed year end statement. As this statement includes additional detail and subcomponent information it can alter a retiree’s cost base and taxable dividend income.

For retirees relying on their investment income to prevent them drawing down on their capital, an unexpected tax bill could be highly detrimental to their cash flow position or value of investment holdings if they need to pay the tax bill from the investment.

Conclusion

The use of ETFs is increasing, and their benefits and limitations continue to divide opinion. As a strategy for retirement planning, Vanguard suggests they are a simple way to build a strong and diversified portfolio, by using a combination of ETFs across asset types and markets (Vanguard 2018).

The pervasive threat of sequencing risk around retirement is significant however and ensuring appropriate asset allocation and adequate diversification will be fundamental to ensure portfolio protection for retirees.

Investors planning for retirement will need to balance the potential advantages of tax efficiencies, simplicity and lower costs, with market risk, liquidity concerns and potential tax complexities when deciding on the suitability of ETFs. This evaluation will also involve considering alternative solutions that could meet the client’s objectives more effectively, such as more guaranteed income streams from annuities or the flexibility offered by SMAs.

Link > Best ETFs of the last 12 months report