At the broadest possible level, every investor shares the same objective: earning a return. Where investors differ, however, is in how much risk they’re willing to take to earn that return, how long they remain invested before needing their money and how large a return they need to reach a financial goal.
These differences closely mirror the three variables that financial advisers routinely discuss with their clients: investment objective, risk tolerance and time horizon.
The interesting part is that these concepts are closely interconnected. A young investor early in their career, for example, typically has a long investment horizon before retirement. In theory, that longer time horizon allows them to tolerate greater short-term volatility because they have more years to recover from market downturns and benefit from long-term compounding.
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Of course, investing is not purely mathematical. Individual psychology and behavioral finance play important roles. Two investors of the same age with identical personal finance situations may have very different comfort levels with market volatility, leading them to build very different portfolios.
That is precisely why clearly defining your investment goals is so important. This ultimately determines which assets are appropriate for your portfolio and which are not.
The need to make those distinctions has never been greater. The U.S. exchange-traded fund (ETF) industry has grown to more than 5,500 funds, spanning everything from broad market index funds to highly specialized leveraged, inverse, thematic and options-based strategies. While this variety gives investors more choice than ever before, it also makes selecting the best ETFs increasingly challenging.
In this guide, we’ll examine five common financial goals U.S. investors pursue. For each one, we’ll discuss the characteristics that investors may want to prioritize when evaluating ETFs and highlight one standout fund that fits that particular objective.
Investing for Retirement
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For most Americans, retirement planning today rests on two primary pillars: employer-sponsored retirement plans, such as a 401(k), and Social Security. Traditional defined-benefit pensions have become increasingly uncommon in the private sector, leaving workers with greater responsibility for building their own retirement savings.
Many investors supplement their workplace retirement plans and Social Security by opening self-directed accounts such as a taxable brokerage account or a Roth IRA. Within these accounts, ETFs have become one of the most popular investment vehicles.
For retirement investing, the objective should generally be long-term compounding while avoiding uncompensated risk. Concentrating too heavily in a single company, sector, country or asset class introduces risks that have historically not been associated with higher expected returns.
One standout here is the iShares Core 80/20 Aggressive Allocation ETF (AOA). The fund charges a net expense ratio of just 0.15%. It maintains an approximately 80% allocation to global equities and 20% to bonds using a diversified portfolio of underlying iShares ETFs in a fund-of-funds structure.
For investors with different risk tolerances, iShares also offers more balanced and conservative allocation ETFs, including portfolios built around 60/40 and 40/60 stock-bond mixes. Each fund is automatically rebalanced, removing the need for investors to maintain their target allocation themselves.
Learn more about AOA at the iShares provider site.
Investing for Your Kids
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Few investors have a longer time horizon than parents saving for their children’s future. With decades available for compounding, younger investors can afford to allocate a larger portion of their portfolio to stocks, accepting greater volatility in exchange for the potential for higher long-term returns.
One notable feature of these accounts is that the investment menu is built around low-cost U.S. equity ETFs. While stock market investments can experience significant short-term volatility, broad U.S. stock indexes have historically delivered strong long-term capital appreciation over multi-decade periods, making them well suited for investors with very long investment horizons.
Parents have several investment options available, but the standout choice is also the program’s default investment: the State Street SPDR Portfolio S&P 500 ETF (SPYM). The fund charges a 0.02% expense ratio, making it one of the lowest-cost ways to gain exposure to the largest publicly traded U.S. companies. To put that into perspective, a $10,000 investment incurs only $2 per year in fee drag.
Although past performance never guarantees future results, SPYM has produced an annualized total return of approximately 15.5% before taxes over the past decade. According to the latest S&P Indices Versus Active (SPIVA) Scorecard, 85.6% of actively managed U.S. large-cap funds underperformed the S&P 500 over the trailing 10-year period.
Learn more about SPYM at the State Street provider site.
Investing for an Emergency Fund
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Previous generations may have kept a rainy day fund in a jar on top of the refrigerator, gradually filling it with spare change. Today, many savvy investors maintain an emergency fund as a reserve readily available to cover an unexpected financial need.
A major car repair, an emergency visit to the veterinarian, an unexpected roof leak, a temporary job loss, travel for a family emergency and funeral expenses are all situations where having cash immediately available can prevent a financial setback from becoming a much larger problem.
When building an emergency fund, investors should prioritize two characteristics above all else before selecting assets: safety of principal and liquidity.
Safety of principal means your money should remain intact regardless of what financial markets are doing. Whether stocks are soaring or experiencing a sharp correction, the amount of cash in your emergency fund should still be there when you need it.
Liquidity is equally important. Emergency savings should be accessible without lengthy lockups, surrender charges or significant withdrawal penalties. After all, money that cannot be accessed quickly is of limited use during an actual emergency.
One ETF designed around these principles is the iShares 0-3 Month Treasury Bond ETF (SGOV). The fund invests exclusively in U.S. Treasury bills with remaining maturities of zero to three months, continuously replacing maturing securities with newly issued Treasury bills. The interest earned is distributed to shareholders each month, and the bond ETF currently yields 3.6%.
Unlike a certificate of deposit (CD) or a high-yield savings account, SGOV is not insured by the Federal Deposit Insurance Corporation (FDIC). However, its holdings are obligations of the U.S. Treasury and mature in only a matter of months, giving the portfolio high credit quality while minimizing interest rate risk.
Short of a U.S. government default, the fund has historically maintained a very stable net asset value. Even if short-term interest rates rise, SGOV’s price is unlikely to experience the sharp declines associated with longer-duration bond funds. Instead, the income generated by the portfolio generally adjusts upward as maturing Treasury bills are replaced with newer securities offering higher yields.
SGOV is also highly liquid. Shares trade throughout the day on an exchange just like a stock, and the ETF currently has a 30-day median bid-ask spread of 0.01%. This helps keep transaction costs to a minimum.
Learn more about SGOV at the iShares provider site.
Investing for Passive Income
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Passive income is one of the most common reasons investors turn to ETFs. Many income-oriented funds distribute cash monthly, allowing investors to generate a relatively predictable stream of cash flow without having to select and manage individual dividend-paying stocks themselves.
Many income ETFs are also reasonably tax efficient. This is because some option-income strategies use accounting treatments that allow a significant portion of their distributions to be classified as return of capital. Rather than being immediately taxable, return-of-capital distributions reduce an investor’s adjusted cost basis, effectively deferring capital gains taxes until the investment is eventually sold.
There are, however, several trade-offs investors should understand. Many high-income ETFs generate their elevated yields by writing covered calls or employing other options strategies. These approaches typically result in higher expense ratios than traditional index funds and add another layer of complexity. They can also limit capital appreciation because covered calls cap a portion of the portfolio’s upside during strong bull markets, meaning these funds may underperform when markets rally sharply.
For most income-focused investors, the goal should be generating a distribution stream capable of supporting planned withdrawals without taking unnecessary risk. Retirees, for example, often reference the 4% rule, which suggests withdrawing approximately 4% of a portfolio during the first year of retirement and adjusting that amount for inflation thereafter.
One ETF that currently exceeds that threshold is the Amplify CWP Enhanced Dividend Income ETF (DIVO). The fund currently offers a distribution rate of approximately 4.8%, calculated by annualizing its most recent monthly distribution and dividing that figure by the ETF’s net asset value. According to DIVO’s July 19a-1 notice, 90% of its latest monthly distribution was estimated to be return of capital.
DIVO owns a relatively concentrated portfolio of roughly 25 to 30 companies selected for characteristics such as consistent earnings growth, dividend growth, strong free cash flow generation and high returns on equity. The portfolio managers then selectively write covered calls on individual holdings. The ETF pays distributions monthly and charges a 0.56% expense ratio.
Learn more about DIVO at the Amplify ETFs provider site.
Investing to Lower Taxes
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Once you’ve fully utilized tax-advantaged accounts such as a 401(k) and a Roth IRA, any additional investments typically need to be made through a taxable brokerage account. While these accounts offer complete flexibility and no contribution limits, they also expose investors to taxes on investment income.
Depending on the investment, taxable income can come from several sources. These include dividends, short- and long-term realized capital gains and ordinary income generated by assets such as taxable bonds and real estate investment trusts (REITs). For investors in higher federal and state tax brackets, these taxes can meaningfully reduce long-term returns.
Fortunately, certain ETFs hold investments whose income may be exempt from federal income taxes. The most common example is municipal bonds. Municipal bonds are debt securities issued by state and local governments and their agencies to finance public infrastructure projects.
These can generally be divided into two categories. General obligation bonds are backed by the issuer’s taxing authority and general revenues, while revenue bonds are supported by income generated from specific projects, such as toll roads, airports, hospitals, water systems or public utilities. In both cases, investors are effectively lending money to the issuing authority in exchange for periodic interest payments and the return of principal at maturity.
Municipal bonds are generally considered a high-credit-quality asset class, although some issuers carry below-investment-grade credit ratings because of financial challenges. For most investors, though, the interest earned from municipal bonds is exempt from federal income tax and, in many cases, is also exempt from the alternative minimum tax (AMT).
A popular municipal bond fund is the iShares National Muni Bond ETF (MUB). The ETF charges a low 0.05% expense ratio and holds more than 6,800 municipal bonds. Its largest state exposures include New York, California, Texas, Illinois, Massachusetts, New Jersey and Florida. The portfolio is also conservatively positioned from a credit standpoint, with approximately 60% of holdings carrying AA credit ratings, with most of the remainder distributed among AAA and A -rated securities.
At first glance, MUB’s 30-day SEC yield of 3.5% may not appear especially compelling. However, iShares notes that investors should instead consider the fund’s tax-equivalent SEC yield of 5.8%. This is an estimate of the taxable yield a conventional bond investment would need to generate to produce the same after-tax income as MUB for investors in the highest federal income tax brackets.
Investors should also know that municipal bond ETFs are also available in state-specific versions. For residents who purchase a fund investing exclusively in bonds issued by their home state, the interest income may also be exempt from state income taxes. This is valuable in high-tax states such as California and New York, where iShares offers dedicated state-specific municipal bond funds.
Learn more about MUB at the iShares provider site.
