Morningstar Advisor - Fall 2008 - 24

Investment Briefs Play Defense in Tough Markets with These ETFs There are ways to put clients’ portfolios in a defensive position other than just going to cash, says Scott Burns, Morningstar’s director of ETF analysis and editor of the Morningstar ETFInvestor newsletter. And ETFs are good vehicles to gain access to these options. “The old belief is that you want to own gold and real estate going into a recession,” Burns says. “Normally, that’s true, but unlike most recessions, we will be headed into this one off of a massive real estate bubble and commodity run. So scratch the gold-and-real-estate prospect.” Instead, Burns recommends looking for ETFs in these sectors: Health Care Historically, health-care spending and health-care stocks have had very little correlation with the ups and downs of the overall economy. That makes fundamental sense because people obtain medical care regardless of whether their home values have increased or decreased. IShares S&P Global Healthcare IXJ contains a stable of large and well-capitalized companies such as Johnson & Johnson JNJ and Pfizer PFE. Biotechnology is another interesting sector to consider, given that the valuations in that area have more to do with actual drug discoveries and approvals than economic trends. Burns’ favorite in that sector is SPDR S&P Biotech XBI. Defense Given the way things are going lately in Russia, Iran, and Afghanistan, it’s probably not likely that defense spending will be cut anytime soon. Defense is one of those sectors that traditionally are safe havens during recessionary times. Burns likes PowerShares Aerospace & Defense PPA. The fund’s holdings are mostly made up of large well-capitalized companies that pay out nice dividends and generally have moats. One of the cons to investing in this sector, Burns says, is that defense always gets bundled with aerospace. The biggest offender and largest holding in the fund is Boeing BA. Commercial aerospace is much more cyclical than defense, but overall, Burns thinks that this fund is weighted more heavily toward defense and should be all right through the downturn. Consumer Staples The fortunes of Wal-Mart WMT, Target TGT, and Coca-Cola KO are generally less dependent on roaring economies than other more discretionary consumer sectors—which is why consumer staples is usually the first sector that people think of when they consider investing for a recession. But Burns has a couple of concerns. First, the runup in commodities has whacked the profits of some of these firms. Second, many consumer-staples companies are drawing significant amounts for revenue from overseas. While that was great over the past five years, the strength of the dollar will cause a head wind for them. Still, according to Morningstar’s equity team, many of these firms are still undervalued. Burns likes Consumer Staple Select Sector SPDR XLP. Fixed Income Protecting capital is paramount in these downturns. Although fixed income underperforms equities over the long term, it has a tendency to outpace them in the front half of recessions. This is especially true when the recession is tied to a deflationary period in asset prices and if there’s an expectation that the Federal Reserve will cut interest rates. Burns likes iShares Lehman Aggregate Bond ETF AGG. This fund has intermediate duration of around 4.5 years and is yielding around 4.5%—not the greatest return in the world, but it sure beats losing money. Burns also likes Vanguard Total Bond Market ETF BND. long-term investment recommendations, says Jim Licato, research and communications manager in Morningstar’s Advisor business. By not considering inflation’s impact, advisors run the risk of overestimating their clients’ future purchasing power, he says. One asset class that has proved itself as a good inflation hedge is real estate, Licato says. Real estate prices tend to rise along with prices in the overall economy. REIT investments have proved to be no different. REITs often invest in commercial property. The income that these properties receive comes via rents, which have a tendency to rise with inflation. And with dividend payouts from REITs growing at a faster rate than inflation, investors have been reaping the corresponding rewards. The graph below illustrates the compound annual returns of four asset classes both before and after considering the effects of inflation. The first bars for each asset class represent the nominal, or unadjusted, returns of each asset class. The second bars illustrate the real, or inflation-adjusted, returns of each asset class. Real returns reflect purchasing power. For example, if your clients invested in cash equivalents in 1972, the money they earned over the period provided them with little purchasing power today. Returns Before and After Inflation 1972-2007 13.0% 11.2% 8.0% 6.3% 3.9% 1.3% REITs REITs Stocks Stocks Bonds after after Inﬂation Inﬂation Bonds Treasury Treasury after bills bills after Inﬂation Inﬂation 8.7% 6.0% Inflation-Adjusted Returns of REITs Outshine Others Because inflation most significantly affects investments over the long run, it is important to examine the returns of different asset classes both before and after inflation when making Over the past 36 years, inflation dramatically reduced the returns of every asset class presented. REITs, however, generated an attractive return after accounting for inflation. In fact, REITs outperformed stocks by nearly 2 percentage points and bonds by more than 4 percentage points. 24 Morningstar Advisor Fall 2008

Morningstar Advisor - Fall 2008

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