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By Christine Benz | 08-04-2011 04:09 PM

ETFs That Can Navigate the Downturn

Morningstar's Tim Strauts shares his ETF picks for investors looking to make defensive or opportunistic plays.

Christine Benz: Hi, I'm Christine Benz for Morningstar. The market has sold-off sharply in recent days, whirling even seasoned investors. Here to discuss some specific ideas for investors navigating the current environment is Tim Strauts; he's an exchange-traded fund analyst with Morningstar.

Tim, thanks so much for being here.

Timothy Strauts: Glad to be here.

Benz: So Tim, you and I were discussing some specific tactics and investments that investors could think about right now. It's a very turbulent environment with lots of fear out there. I want to talk about a couple of categories. The first is true defensive hedges that investors could embrace in their portfolios at a time like this. What are the key categories or key ETF types that come to mind?

Strauts: When you're looking at a defensive hedge right now, there are not too many places to hide in a market like this. But there are two areas you could look at right now. One is in gold, and in that space we like iShares Gold IAU. The downside to gold right now is that it's been on a great run, pricing now at $1,600 an ounce. For the last few days, it's been positive where the market's been selling off, but you might be getting a little bit of a frothy valuation.

Benz: Absolutely, yeah.

Strauts: Another place you should look is U.S. Government bonds. People don't really like U.S. Treasuries. Everything you read in the press is all about the bond bubble, but what's one of the best-performing asset classes during the last few years? U.S. government bonds.

Benz: And then a true flight to safety, even despite all the worries about what's been going on in Washington and everything else, we've seen that Treasuries have actually held up pretty well.

Strauts: Yeah, even with the debt-ceiling talk, 10-year Treasury bonds were actually rising in value. The yields were coming down in price, even with all that talk. So, in that space you could look at a fund like iShares 7- to 10-Year Treasury, ticker IEF, if you're looking there. But again, it's also done very well. So, if the market turns here, it will be negative in the next few days.

Benz: I always say if you're employing a strategy like this, it's better to kind of tiptoe in, rather than say, "OK, I'm going to take 30% of my equity exposure and put it here." Dollar cost averaging will be your friend in an environment like this.

Strauts: Definitely.

Benz: So, another category that we wanted to talk about is, say, you're staying within stocks and you want to maintain equity exposure, but you want to give your portfolio a little bit of a defensive cast. What would the go-to ETFs be for someone who is looking to do that?

Strauts: There are a bunch of different options. You want to look at defensive sectors. So you can look at utilities. That sector has always become the number-one place people go to during these kind of panic times.

Benz: So the idea is that's utilities are regulated and people pay their utilities bills regardless of what's going on?

Strauts: Yes, utilities usually have little debt. Their growth rates are capped, but they have a persistent base of customers. And they pay good dividends. The Select Sector Utilities Index, ticker XLU, has a yield of more than 4% right now, which in this environment is pretty attractive. Another area you could look that is defensive is health care. The Select Sector Healthcare Index, ticker XLV. Now there is some talk about with the debt-ceiling deal that if this committee doesn't make a deal, that they'll cut Medicare, and that could create some overhang on this sector.

Benz: Some cost-containment going on, yeah.

Strauts: It's still a defensive sector, and in a bear market, it should still outperform the S&P 500.

Benz: And the more discretionary sectors for sure.

Strauts: And then, lastly, you could also look like a dividend index, such as iShares High Yield Equity. It's more of a diversified by not just focusing on one sector.

Benz: Right, a broad basket.

Strauts: Yeah. The sectors it focuses on are health care, consumer staples, telecom, and utilities. These are all areas of the market that are going to have a lower beta to the S&P 500.

Benz: So it doesn't give you a lot of exposure to the financials sector, which has been kind of a spooky area for a lot of investors. The index is not heavy on financials unlike a lot of other high-yield-oriented index strategies.

Strauts: Yeah, a lot of the other dividend funds pile into the financials to get that yield. This fund doesn't do that. I would say also, as a disclosure, that it is a Morningstar Index that the fund tracks.

Benz: Last but not least, I wanted to talk about what long-term investors who are feeling opportunistic, and feeling like maybe they can capitalize on some of this selling, what should they be looking at? What should they be thinking about? What ETFs do like for them?

Strauts: Well, on the more conservative side, opportunistically, you could look at like a large-cap value index, and there are many out there. One of the most popular is the iShares Russell 1000 Value, ticker IWD. And if you're looking to be a little more aggressive, you could look at the energy sector, such as Select Sector Energy Index, ticker XLE. Now, that portfolio has a lot ExxonMobil and Chevron; about 30% of the portfolio is in those two stocks, which are pretty defensive plays in themselves. Longer term, the outlook for energy and oil is positive with commodities run here. So, you might find some opportunity there.

Benz: And our equity analysts, I know, think, some of the big players, Exxon in particular, are pretty cheap right now.

Strauts: Yeah, definitely, and overall, you want to try to stick with large-cap investments, in a higher-volatility environment. The small caps, well, which have had a great run during the last few year, are going to be much more volatile. In the last few days, you've seen the small caps have drawn down a lot more than the large-cap stocks. So if you're being defensive, stick with the large-cap space.

Benz: OK, Tim. Thanks for the great advice at a time like this. We appreciate you being here.

Strauts: Great.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.


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