Matthew Frankel, Jordan Wathen, and Dan Caplinger, The Motley Fool
Updated
While individual stocks can be an exciting way to invest, they aren't always the best choice for IRA investors. This is especially true if you're relatively new to investing, as it can be difficult to create a properly diversified retirement portfolio with limited funds and limited knowledge.
Fortunately, there are plenty of low-cost exchange-traded funds (ETFs) that can allow you to invest in a variety of stocks, and with minimal fees. We asked three of our contributors for their favorite IRA index funds, and here's why they chose the Vanguard High Dividend Yield ETF (NYSEMKT: VYM), the Vanguard Dividend Appreciation ETF (NYSEMKT: VIG), and the iShares Core S&P Mid-Cap ETF (NYSEMKT: IJH).
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Income and downside protection are a great combination
Matt Frankel (Vanguard High Dividend Yield ETF): The Vanguard High Dividend Yield ETF is one of my favorite ETFs in the market, especially when used in a tax-advantaged account like an IRA.
The first, and most obvious, reason to love the ETF is for the income it generates. The Vanguard High Dividend Yield ETF tracks an index of stocks that have above-average dividend yields, specifically excluding REITs, and currently pays about 3.5%. The fund is rather top-heavy, meaning that the largest stocks make up a substantial percentage of its assets, but the top holdings include rock-solid companies like Microsoft, Johnson & Johnson, and JPMorgan Chase, just to name a few.
Before you retire, these dividends will help your investment compound faster, taking full advantage of the tax-advantaged nature of your IRA. And after you retire, the high yield can provide a reliable stream of income.
Next, and not as obvious, is for the downside protection. Generally speaking, dividend-paying stocks tend to do better than their non-dividend counterparts during corrections and recessions, and this is especially true with mature companies like those that make up the fund's big holdings. With many experts forecasting a correction in 2018, this could be a smart way to play defense.
Finally, like most Vanguard products, the High Dividend Yield ETF is cheap. With an expense ratio of just 0.08%, you'll get to keep most of your gains.
Dividends with a dollop of growth
Dan Caplinger (Vanguard Dividend Appreciation): Dividend stocks have been some of the best long-term performers in the stock market, and exchange-traded funds that track indexes of dividend stocks have a lot of appeal for investors who want their powerful combination of current income and prospects for growth down the road. Like Matt and his recommendation of sister dividend ETF Vanguard High Dividend Yield, I respect the low expenses and ample liquidity that the Vanguard Group provides.
Vanguard Dividend Appreciation takes a slightly different angle from many other dividend ETFs in that rather than emphasizing current yield, it looks for stocks that have demonstrated a track record of growing their dividend payouts over time. That strategy can end up investing in stocks with relatively low dividend yields right now, with the expectation that subsequent dividend growth will result in above-average yields in the future. Yet ETF shareholders don't have to give up all their income, as the fund's current distribution yield of 1.8% is very close to the market's overall average, and average annual returns of nearly 14% over the past five years are quite attractive. For retirement investors who don't necessarily need maximum income right now but want to boost their chance of bigger future payouts, Vanguard Dividend Appreciation makes a solid choice for an IRA.
A fund fit for smaller stocks
Jordan Wathen (iShares Core S&P; Mid-Cap ETF): The two index funds my colleagues picked are great for creating income from large-cap stocks, so I'll round it out with a mid-cap index fund that invests in smaller companies. The iShares Core S&P Mid-Cap ETf holds approximately 400 mid-cap companies with market values ranging from $1.6 billion to $6.8 billion.
Mid-cap stocks have historically produced higher returns than large caps, thanks to the fact that mid caps tend to be less mature businesses with more room for growth, and because large-cap companies often acquire them at a premium. That said, most of the return comes from capital appreciation rather than yield, as this fund yields only about half that of large-cap funds.
I like this index fund because it's based on the S&P MidCap 400 Index, which is made up of 400 companies that are generally too small for inclusion in the S&P 500 Index. Thus, it is a great complement to an investment in an S&P 500 index fund, as there is no overlap (shared holdings) between the two indexes. Best of all, this fund is downright cheap, carrying an expense ratio of just 0.07% of assets, ensuring that fees don't put much of a drag on its long-run returns.
Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Dan Caplinger owns shares of Vanguard Dividend Appreciation ETF. Jordan Wathen has no position in any of the stocks mentioned. Matthew Frankel has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Johnson & Johnson. The Motley Fool has a disclosure policy.
