Not all investors are interested in riding the volatile ebbs and flows of the market just to fund their need for a modest income stream. If anything, aggressive growth investors have it easy, as an entire portfolio can be constructed in a matter of minutes by scanning headlines and buying the hottest go-go momentum stocks or sectors. Meanwhile, retirement income investors face different challenges. Cobbling together a conservative, diversified, and balanced portfolio that lives up to its name can be more difficult than most anticipate.

Seeking low volatility and preservation of invested capital usually equates to an underperforming mix of uninspiring assets, but it doesn’t have to. In fact, there are many effective strategies that retirement investors can utilize to fill their income gap. Using exchange-traded funds (ETFs) is one of them.

Key Takeaways

  • Retirees have different investment needs than younger people who have a longer time horizon and can take on more risk.
  • Many retirees seek a portfolio that is conservative but diversified, and that possesses low volatility while assuring the preservation of capital.
  • Exchange-traded funds (ETFs), baskets of securities that trade on an exchange like stocks, are a good option for retirees to consider.
  • Retirees should consider stock exposure in low-cost and diversified funds and bond exposure in managed funds.
  • For alternatives, retirees can consider real estate investment trusts (REITs), master limited partnerships (MLPs), and preferred stocks.

Factoring in Your Needs

You begin the process of creating a retirement portfolio by determining how much income you need and putting that alongside your expectations for total return. For example, if you need between 3% to 4% in income from your portfolio, you should generally expect a total return in the neighborhood of 6% to 7%. The spread between your income goal and your total return goal can be thought of as a buffer for inflation, medical expenses, travel budget, or just an added safety net.

Having a good idea of your needs is important because it correlates directly with the amount of risk you will need to take to achieve that rate of return. It also directly influences your asset allocation and the type of ETFs you ultimately will be purchasing. For clients in our Strategic Income Portfolio, we take these same steps to carve out limits on the amount of stock, bond, and alternative income assets. For example, a conservative income investor with the same goals listed above could set an asset allocation limit at 35% stocks, 50% bonds, 10% alternative, and a 5% cash buffer. Once those limits are locked in, you can begin to shop for ETFs that fall in line with your income goal and have potential upside opportunities to meet your total return objective.

Naturally, maintaining low investment expenses is an important consideration with any portfolio. With that in mind, you should begin by building the bulk of your core stock exposure in low-cost and widely diversified funds. A few of our favorite examples include the Vanguard High Yield Dividend ETF (VYM) or the iShares Core High Dividend ETF (HDV). From there, an investor can begin to shop for more exotic or esoteric strategies, such as fundamentally weighted or smart beta indexes that screen-specific criteria for their constituents. A few popular examples include the iShares MSCI U.S. Minimum Volatility ETF (USMV) or the WisdomTree U.S. Total Dividend Fund (DTD).

Like any investor, a retiree looking to include ETFs in their portfolio needs to weigh their income needs with their willingness to take on risk.

Fixed-Income Exposure

The same rules should also apply when selecting fixed-income exposure. However, several actively managed fixed-income strategies have shown to outperform passively managed index strategies over time. This is primarily due to index composition rules and weighting methodology. This is oftentimes in direct conflict with the fundamentals of owning debt securities. To overcome these subtle anomalies, investors could choose a fund such as the PIMCO Total Return Fund (PTTRX) or the PIMCO Diversified Income ETF (DI).

Once that core exposure is established, a key component to fixed-income investing is using sectors to enhance income or offset volatility from other sleeves within the entire portfolio. If a larger income gap needs to be filled, an investor could choose a fund such as the iShares High Yield Corporate Bond ETF (HYG) or the actively managed, low duration AdvisorShares Peritus High Yield ETF (HYLD). 

Accounting for Equity Volatility

Conversely, an investor concerned with the volatility that might emanate from the equity sleeve during a market correction could opt for the Vanguard Intermediate-Term Bond Fund (BIV) or the Vanguard Intermediate-Term Corporate Bond ETF (VCIT). Essentially, this strategy would extend the average duration of the fixed-income sleeve to effectively counterbalance equity volatility, assuming interest rates fall. Using this type of strategy to offset volatility is at the core of conservative investing, assuring the portfolio remains balanced and performs admirably in any market environment.

Don’t Ignore Alternatives

Lastly, selecting alternative income assets such as real estate investment trusts (REITs), master limited partnerships (MLPs), or preferred stocks can enhance your dividend streams while simultaneously offering non-correlated price movement. These asset classes can be an excellent way to diversify your portfolio and lower overall volatility by providing a counterweight to traditional stocks and bonds.

The iShares Trust Preferred and Income Securities ETF (PFF), Vanguard REIT ETF (VNQ), and Alerian MLP ETF (AMLP) are examples of alternative income ETFs that offer significantly higher yields than traditional dividend-paying equities or fixed-income securities. These funds can be used to complement existing holdings and protect your portfolio from inflationary forces.

The Bottom Line

The implementation of a conservative income portfolio using ETFs will require research and balance to successfully achieve your goals. Keeping a focus on your income needs and risk tolerance will help guide portfolio management decisions to ensure that you meet your total return objective. 

Disclosure: At the time this article was first published, principals and clients of FMD Capital Management held positions in VYM, PFF, and VNQ. 

FMD Capital Management, its executives, and/or its clients may hold positions in the ETFs, mutual funds, or any investment asset mentioned in this article. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities. The views reflected within are solely those of FMD Capital Management and their Authors.