Top Five ETF Buys If We Fall Off Fiscal Cliff

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The country faces binders full of tax increases and government spending cuts that could severely hurt the economy in the New Year if the president and the Republican-led House fail to steer clear of the fiscal cliff.

Both sides profess wanting to avoid the chaos that would ensue. But just in case, how can ETF investors prepare for the worst-case scenario in which tax hikes -- totaling $400 billion (through fiscal-end 2013) -- and cuts to Medicare, unemployment benefits and other programs go into effect?

"Almost all forms of 'risk assets' are likely to fall in price as the market would discount a greater degree of political and economic uncertainty," said Alan Zafran, partner at Luminous Capital in Menlo Park, Calif.

"(It) will increase the probability that the Fed will continue to expand its balance sheet to keep the economy moving forward," said Adam Thurgood, managing director at HighTower Las Vegas with about $800 million under management. That's financial parlance for printing money, which weakens the dollar and fans inflation.

After the market corrects, investors will return to the stock market, where they could make higher returns than sitting in cash, asset managers say. They recommended buying MLPs (master limited partnerships), REITs (real estate investment trusts), gold, bonds and foreign government bonds.

Here's a brief overview of the most widely traded ETFs tracking those groups and the rationale for investing in them.

• MLPs. JPMorgan Alerian MLP Index ETN ( AMJ ): "MLPs pay a yield of nearly 7%, compared to 2.2% for the stock market as a whole and well under 2% for 10-year bonds," said Mark Martiak, senior wealth strategist at Premier Wealth/First Allied Securities in New York City.

MLPs are required to pay quarterly distributions to investors, who are considered "partners." MLPs do not pay corporate taxes on both the state and federal levels. The distributions are taxed at the investor's tax rate. Investors can also get a tax write-off by taking a pro-rated share of the MLP's depreciation.

Because MLPs are given generous depreciation allowances, as much as 90% of each distribution is classified as a "return of capital," which is tax-deferred until shares of the MLP are sold, explains Rich Winer, president of Winer Wealth Management in Woodland Hills, Calif., with $20 million in assets under management.

"The return of capital is taxed when the investment is sold. Because the deferral of taxes was on ordinary income, the deferred amount is taxed as ordinary income when shares of the partnership are sold," Winer said.

On average, 80% of MLPs' payouts are tax deferred and only 20% are taxed as ordinary income. MLPs offer tax advantages on top of a potential for price appreciation, says Darren Schuringa, principal at Yorkville Capital Management in New York. "Our research shows the after-tax yield of MLPs would be 52.4% greater than dividends if qualified-income rates move back to 39.6%," said Schuringa, whose firm manages $500 million in assets. "MLPs provide exposure to the booming U.S. energy industry without having direct exposure to the spot price of natural gas and other commodities."

• REITs . IShares Dow Jones U.S.Real Estate ETF ( IYR ) andVanguard REIT ETF ( VNQ ): The Fed's third quantitative easing plan, or QE3, involves buying $40 billion in mortgage-backed securities every month with no announced end date. The resulting low interest rates are aimed at making homes more affordable, benefiting real estate firms and homebuilders. They also benefit from refinancing their corporate debt and mortgages.

REITs have to distribute 90% of their income to shareholders because they're exempt from paying taxes at the trust (or corporate) level. So they tend to pay fatter yields than stocks. A part of a REIT's dividend payout may be considered a nontaxable return of capital, which reduces the shareholder's taxable income. This is a complicated individual tax issue that should be discussed with an accountant or tax preparer.

"REITS were never subject to the lower tax rates on dividends, so the changing (increasing) tax rates are not impacting REITs to the degree they are impacting other dividend-paying stocks," said Zafran.

That would make them more appealing over other dividend-paying stocks under President Obama's proposed increases on capital gains.

"There would be an increase in the capital gains tax to 20% on high earners and dividends would be taxed as ordinary income for individuals making over $200,000 and couples making over $250,000," David Mazza, head of ETF investment strategy at State Street Global Advisors, wrote in a client note Wednesday.

REITs are a good source for income that are uncorrelated with stocks and bonds, while offering diversified access to health care, apartments and commercial real estate, said Martiak of Premier Wealth.

• Gold .SPDR Gold Shares ( GLD ): Low interest rates and quantitative easing aims to weaken the greenback to make U.S. exports cheaper overseas to boost sales. A weaker dollar fuels inflation and makes dollar-denominated commodities such as gold and oil more expensive.

"The break in commodity prices (Wednesday) is likely an overreaction because I am looking for inflation due to the money printing and the fact I see them kicking the can down the road by extending the deadline for the fiscal cliff," said George Kleinman, president of Commodity Resource Corp. in Incline Village, Nev., who bought gold Wednesday.

• Bonds .Vanguard Total Bond Market ETF ( BND ) and iShares iBoxx $Investment Grade Corporate Bond (LQD): Barack Obama's re-election went hand in hand with Ben Bernanke staying put as the Federal Reserve chairman. He will likely continue his policies of keeping interest rates low. He will also likely keep buying long-dated government bonds, while selling short-term bonds, known as Operation Twist. Bond prices will rise until interest rates go up. Prices and yields move in opposite directions.

"Bonds are still considered the 'go-to' safe haven in times of duress, although I see them as a bubble that will eventually burst," said Kleinman. "The supply is going up, the demand is going down from foreign buyers and rates cannot be kept this artificially low for infinity."

• Foreign bonds .SPDR Barclays International Treasury Bond ETF (BWX), iSharesS&P/Citigroup International Treasury Bond Fund (IGOV), iSharesJPMorgan USD Emerging Markets Bond Fund (EMB),Market Vectors Emerging Markets Local ETF (EMLC): "Investors seeking higher yields may want to look at European government and emerging markets bonds," said Winer of Winer Wealth Management. "I think economic growth in the U.S. and abroad will continue to pick up, so there's less risk in high-yield bonds and emerging markets bonds."



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: AMJ , BND , GLD , IYR , VNQ

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