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Before fintech was a “thing,” arguably the most disruptive events in terms of the consumer-facing side of the financial services industry, certainly on the fund management side, were the debuts of index funds (1975) and exchange traded funds (1993 in the U.S.)
Looking at those dates, particularly the one pertaining to ETFs, it’s not surprising that there are some demographic preferences pertaining to fund structures. Put simply, baby boomers prefer actively managed mutual funds, though in recent years they have gravitated to passive structures. Conversely, the popularity of ETFs and index funds increases from Gen X to millenials to Gen Z.
Consider this: in 2021, the the Investment Company Institute observed that the average mutual fund investor was 51 years old while their ETF counterpart was 45. Given the increasing popularity of ETFs among advisors and clients alike, it’s possible that gap has narrowed, but the point is many “seasoned” clients may still prefer mutual funds and are apt to be holding such funds in accounts outside of their advisors’ purviews.
However, the index fund and ETF structures are appealing to retirees and multiple fronts and advisors should be articulating those advantages to clients.
Clients Love the Dough
A significant portion of the allure held by index funds and ETFs over mutual funds revolves around fees. While fund fees have steadily declined across the board over the years, the advantage held by ETFs and index funds over mutual funds is wide, creating significant cash flow benefits for clients.
“For income-centric retirees, the small fees that index funds and ETFs typically levy ensure that more of their dividends flow through to shareholders,” notes Morningstar’s Christine Benz. “It’s all but impossible for more-expensive products with similar mandates to generate a competitive yield without taking on additional risk. And while the original yield-focused index products often had embedded hefty sector bets, and paid for it during the financial crisis when banks slashed their dividends, the best dividend-focused index products today control for those biases.”
Beyond the obvious benefit of lower fees, passively managed funds offer clients tax benefits. Those perks can amount to added savings, which are important to any client, particularly retirees. At the asset class level, benefits such as limited capital gains events, are more prominent with equity funds than fixed income products. The point is the benefits exist and can be harnessed to improve client outcomes.
“Moreover, controlling taxable income in retirement doesn't just have the potential to lower your tax bill; it may also reduce the extent to which your Social Security income is taxed and reduce your susceptibility to Medicare premium surcharges that apply to high-income Medicare enrollees,” adds Benz.
Another Reason Index Funds Matter to Retirees
As advisors well know, a retirement portfolio should be considerably less aggressive than those constructed by clients in their 30s and 40s. A retirement portfolio will typically feature some cash, elevated fixed income holdings and reduced equity exposure.
That methodology is fine, but with inflation proving sticky, retirees need all the advantages they can terms of bolstering portfolios that are reducing risk while also likely reducing reward. Passive fund structures can assist with that objective.
“Assume a retirement portfolio consists of a 10% cash position and 40% in bonds and 50% in stocks and earns 5% on an annualized basis over the next decade. If an investor pays 0.75% in asset-weighted expenses on such a portfolio, her return shrivels to 4.25%; she has ceded 15% of her gains,” concludes Benz. “But if she’s able to limit expenses to 0.10% per year, her take-home return is 4.90% and she has surrendered just 2% of her return. As Vanguard founder Jack Bogle put it, you get what you don’t pay for, and not paying for investments is especially important when returns aren’t especially high to begin with.”