Active ETFs have become a popular alternative to passive ETFs and mutual funds. Rather than blindly following a benchmark index, these fund managers make tactical decisions based on current market conditions. At the same time, they have significantly lower expense ratios and trading costs than their mutual fund counterparts.
Let’s take a look at four active ETFs that could help protect retirement portfolios from rising inflation and other risks while maintaining an attractive base level of income.
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Why Choose Active ETFs?
Mutual funds remain the most popular option for retirement investors. Many fund managers were hesitant to launch active ETFs because of their transparency and potential to cannibalize higher fee mutual funds. But in 2019, the SEC unveiled new rules paving the way for active non-transparent ETFs and there are now many more active ETF options.
At the same time, ETFs provide investors with numerous cost advantages over mutual funds. Their expense ratios tend to be much lower, and their structure shifts the costs of trading from every shareholder to those making the trades. As a result, long-term holders pay far less in expenses, and trading fees don’t cannibalize their returns.
There are hundreds of different active ETFs with more launched each year. While the ARK Innovation ETF (ARKK) captured headlines, active fixed income and high yield ETFs have become a silent winner among retirement investors. These funds have more agility than their passive ETF counterparts, enabling better risk-adjusted returns.
Balancing Risk with Yield
Fixed income plays a central role in almost every retirement portfolio. With inflation on the rise, many retirement portfolios could see a steep drop in their bond holdings. Some passive (and active) funds mitigate these risks by holding low duration bonds, but lower durations result in lower yields and pressure retirement income.
The First Trust Low Duration Opportunities ETF (LMBS) invests in mortgage-backed securities to mitigate these risks. With a diverse portfolio of more than 1,400 securities with a weighted average effective duration of 2.64 years, the fund provides an attractive 2% 12-month distribution rate—that’s a lot higher than many low-duration government or corporate bonds.
For those seeking even higher yields, the First Trust Preferred Securities & Income ETF (FPE) invests in preferred securities and other income-producing debt instruments with a nearly 6% 12-month distribution rate. Preferred stocks and other non-bond sources of income could be less sensitive to interest rate risk, while convertible securities offer potential capital gains upside.
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Increase Diversification
Diversification is essential to maximize risk-adjusted returns in retirement portfolios. For instance, international diversification helps ensure that any domestic downturn in the U.S. doesn’t affect the entire portfolio. Emerging markets and other higher-growth regions can also improve capital gains and income to boost risk-adjusted returns.
The SPDR SSgA Global Allocation ETF (GAL) invests in a portfolio of ETFs to maximize capital appreciation. In particular, the fund invests at least 30% of its assets in securities of issuers economically tied to countries other than the U.S. and about 60% of its assets in equity securities. However, these percentages vary based on the advisor’s tactical decisions.
In addition to geographic diversification, the Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC) invests in commodity-linked futures and other securities with exposure to commodities, while providing a 35% 12-month distribution rate. These commodities have a low correlation to other assets and could benefit from rising inflation.
The Bottom Line
Active ETFs provide retirement investors with an alternative to higher-cost active mutual funds or sub-optimal passive ETFs. In particular, retirees looking to reduce risk or boost their income may find that active ETFs focused on fixed income provide better risk-adjusted returns than their passive counterparts—especially with interest rates on the rise.
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