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."