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Total Returns and ETFs For Retirement

David Haviland

This article is part of a regular series of thought leadership pieces from some of the more influential ETF asset managers in the money management industry. Today's article is by David Haviland, managing partner and portfolio manager for Beaumont Capital Management based in Needham, Massachusetts.

Throughout history, bonds were a key component of achieving the level of yield needed for retirement. In today’s low-interest-rate environment, we have to find new ways to meet the retirement needs of investors.

Throughout the 1980s, 1990s and 2000s, many financial plans were constructed with the assumption that the portfolio could produce enough income to allow for 4-5% annual withdrawals during retirement.

Over the past 35 years, interest rates have fallen around the globe, and today bond yields are too low to meet a typical 4-5% annual withdrawal from a retirement portfolio. Today the 10-year U.S. Treasury bond yield is around 1.9%; 10 years ago, this yield was about 2.5 times higher—around 5%.

Of course, an investor can stretch for higher yield, but this invites additional and often-unintended risks, whether it be credit risk, maturity or duration risk and/or other unforeseen portfolio threats such as liquidity and issuer concerns.

Dividend Yields Have Also Fallen

Today’s dividend yields are also at relatively low levels compared with historical payout rates. The current dividend yield of the S&P 500 Index is 2.1% compared with the long-term average of 4.4%.

With both interest and dividends rates so low, how do we as an industry meet our clients’ retirement living needs? We believe the answer is a “total return” strategy.

The concept of using total return to meet retirement income needs is relatively simple. One starts by combining the dividend and interest income from the portfolio and supplementing this with—usually modest amounts of—capital gains. If executed properly over time, the combination of the two can create adequate income, position the portfolio to keep up with inflation and maintain a more stable asset base over time.

Equity returns over short time periods have, and likely will, vary widely. Since 1945 the long term annual growth rate for the S&P 500 has averaged about 7.2% before dividends. We are going to be more conservative and assume equities will grow at 6% per year over time.

The 6% annual growth over time is split into half, with each half being assigned a different task: 3% will be used for supplemental income and the other 3% will be tasked to grow and keep up with inflation.

Two More Steps

What about equity risks? All markets, especially equity markets, undergo periods of failure. To account for this risk, we further recommend two additional policies to complete this overall strategy.

First, we would mandate two to three years’ worth of income needs to be invested in cash and ultra-short bonds so that when markets do fall—such as during 2008-09—there is sufficient cash available to meet client income needs during these downturns.

Knowing there is a secure income source that is not exposed to typical market volatility helps mitigate client anxiety and helps prevent additional drawdowns when the investment’s prices are depressed.

As an example, let’s use a $1 million portfolio, and a $40,000 annual income need which is 4% of the portfolio. If the portfolio were to drop 30% to $700,000, the same $40,000 would represent a 5.7% withdrawal.

Given the historical two- to three-year time period that most bear markets have lasted, the markets would be well on their way to recovery, and our portfolio’s stock and bond principal would still be intact and poised to recover. Having this cash reserve allows the investor to leave the portfolio alone during the bear market and assumed recovery period.

Tactical Vs. Strategic Management

Second, for the equity portion of the portfolio, we would recommend investing a portion in tactical versus strategic management. Using tactical management as a piece of the portfolio allows part of the equity allocation to avoid at least a portion of the drawdowns that occur during bear markets. This can shorten recovery time and reduce client anxiety even further, and keeps the client from making emotional buy-and-sell decisions.

As an example, the table below uses a $1 million hypothetical portfolio, a 4% annual income need and assume investing in low-cost, long-only ETFs to represent each asset class to show how this would work:

The example has 2 1/2 years of income allocated to either a money market or ultra-short bond ETF; while $300,000 of the portfolio is allocated to other bond ETFs.

Of this, the example would recommend investing half passively in a low cost bond index ETF such as the iShares Core U.S. Aggregate Bond (AGG | A-98) and half in an actively managed bond ETF, such as the SPDR DoubleLine Total Return Tactical ETF (TOTL | C), where the manager has the ability to seek additional alpha during most bond market environments.

High-Dividend-Yielding ETFs

Next, the example invests $300,000 in three passive, high-dividend-yielding equity ETFs: the O’Shares FTSE US Quality Dividend (OUSA); the iShares Select Dividend (DVY | A-70); and the iShares Core High Dividend (HDV | A-85).

Multiple ETFs are intentionally used to diversify from over-reliance on one asset class such as utilities or REITs. Each ETF follows a different index, and together they could produce a dividend yield that is more than 50% higher than the S&P 500. This core equity allocation does much of the heavy lifting … it is positioned to grow over time and should provide an elevated income stream for the client.

Finally, the $300,000 growth equity allocation could be equally invested into two tactical growth ETF strategies. Of course, we are biased and have used two of our strategies that we know well. However, you could use other tactical strategies that seek to provide defense when markets struggle.

The purpose here is to show the benefit of diversification using one ETF strategy that is tactically constrained to the sectors of the S&P 500, and the second being a tactically unconstrained, global growth strategy.

Tactically Constrained & Unconstrained

Tactical strategies can be selected where the defensive mechanism used by each can vary. For example, a tactically constrained sector strategy may use cash for a defensive position, while a tactically unconstrained, global growth strategy may remain fully invested and rely on geographical and asset class selection to try to avoid failing markets. The idea, in general, is to seek diversification by using multiple, actively managed portfolios.

The results of this sample portfolio construct show numerous advantages.

The portfolio is a 60% equity/40% fixed-income portfolio. It has exposure to both international and domestic bonds and equities. While the portfolio above is tilted to large-cap equity, all market caps can be used in the allocation.

Thirty percent of the portfolio has the ability to be defensive during periods of market failure, and 2 1/2 years of income are in more conservative positions to help ensure clients can take their withdrawals without compounding the negative effects of a bear market. The portfolio is designed to meet current as well as future income needs by allowing for growth to counter the effects of inflation.

Most importantly, this total return construction should: smooth out portfolio drawdown and volatility when compared with an all-equity portfolio; allow the client to remain invested; and help them avoid making emotional buy/sell decisions at the worst possible times.

Beaumont Capital Management (BCM) is a tactical ETF strategist and uses the ETFs listed above when investing its strategies. Several ETF families were included to illustrate there are a number of choices and countless combinations of ETFs that can be used to implement the Total Return concept. BCM is not recommending any ETF or ETF family over another. David Haviland can be reached at (844)-401-7699, or at salessupport@investbcm.com. Please read the important disclosures.

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