By Michael Krause
President, AltaVista Independent Research
(Editor, www.etfresearchcenter.com)

News about a slowdown and potential recession has investors spooked and clamoring for continuous interest rate cuts from the Federal Reserve. Even in a large, diversified equity portfolio, ETFs can be an effective tool to adjust allocations to protect you from slowdowns both in the U.S. and abroad. If a current downturn in stocks turns out to be more enduring than a simple 'correction,' how should ETF investors play it?

Some on Wall Street believe that the rest of the world economy is "decoupling" from that of the U.S., and therefore investors should simply shift assets away from the U.S. to ride out the storm. But recently cracks began to appear in this narrative: after rising for most of the year, earnings estimates for firms in the iShares MSCI EAFE fund (EFA), composed of stocks in developed markets outside the U.S., have started to be revised lower, mirroring earlier developments for the S&P 500 (Figure 1). And yes, the primary culprit in these estimate cuts is financial firms.

Figure 1: Trend in Current FY Estimates
Jan. 07 = 100

Source: AltaVista Independent Research

So if you can't mitigate a U.S.-led downturn by shifting away from U.S. stocks, what can you do? One answer might be to get more defensive everywhere. Fortunately, ETF investors have hundreds of choices thanks to the many innovative index products that have been introduced in recent years.

We've constructed a set of alternatives to three popular benchmark ETFs - the S&P 500 SPDR (SPY), the iShares MSCI EAFE fund (EFA) and the Vanguard Emerging Markets fund (VWO) - using newly available, lesser known funds that our fundamentally-driven analysis suggests will be more resilient in the event of a downturn (Table 1).

Table 1: ETFs for a downturn

Note: The AltaVista Long Term Annual Return forecast (ALTAR™ score) is AltaVista's proprietary measure of an ETF's likely return to new shareholders in the coming years, based on historical profitability over the business cycle, current valuations, and fund expenses. For more information go to www.etfresearchcenter.com/altar

The criteria for selecting each alternative fund were twofold:

• Superior profitability. Each fund had to have superior profitability in both good times and bad, on the basis that if earnings do indeed head south perhaps they won't have as far to fall. Specifically, we measured the historical Return on Equity of firms in each index fund (a broad and comparable measure of profitability) to show that these firms, while not immune from the ups and downs of the economy, could be counted on to produce superior profits for shareholders throughout the cycle (Figure 2).

• Valuations. Since relatively attractive valuations should provide some cushion in the event of a bear market, each alternative fund had to have a higher ALTAR™ score - our measure of an ETF's overall investment merit - based on profitability and market prices in relation to those profits.

Figure 2: Historical Return on Equity, Range & Average

Note: Based on pro forma calculations for current index constituents, 2002-07E

We selected the mega-cap Rydex Russell Top 50 (XLG) as an alternative to the S&P 500 SPDR (SPY). Though we agree with the conventional wisdom that large caps are currently more attractive than small, the sweet spot within large caps appears to be in mega-cap stocks, despite being the ones that get all the media attention. Firms in XLG have more foreign sales and consistently higher level of profitability, while selling at slightly cheaper valuation multiples. Finally, XLG is well balanced by sector, an advantage since traditional sector rotation models have broken down.

Outside the U.S. our criteria were met using a dividend-oriented approach. Both the iShares MSCI EAFE fund (EFA) of stocks in developed-markets outside the U.S. and the Vanguard Emerging Markets fund (VWO) were panned in favor of competing funds from WisdomTree.

Firms Should Have Faster Earnings Growth in 2008

The WisdomTree DEFA fund (DWM) is similar in concept and coverage to EFA but is a dividend-weighted fund. But lest you think "dividend equals stodgy slow growth" our bottoms-up analysis of constituent firms in each fund shows that those in DWM are expected to have faster earnings growth in 2008, but with cheaper valuations and, of course, a better dividend yield of around 4.4%. It also has less exposure to Japan, with its paltry payouts and consistently low profitability.

Meanwhile the WisdomTree Emerging Markets High Yield Equity fund (DEM) appears to be a prudent defensive choice after stellar gains in emerging markets over the past few years that has actually caused their price-to-earnings multiples to exceed those of companies in developed markets - a potential warning sign that valuations in emerging markets have become stretched. Unlike some other high-yield funds, DEM is well balanced by sector, and its reasonable valuations combined with better-than-average profitability should provide a cushion for investors in a bear market.

Of course, if you knew ahead of time that global stock markets would decline in 2008 you could just sell the market short. But such declines are far from certain. However, given the uncertainties and the increasing likelihood of at least a widespread profits recession, we think these funds are well positioned to navigate a slowdown while providing some upside should markets move higher.

The AltaVista Long Term Annual Return forecast (ALTAR™ score) is AltaVista's proprietary measure of an ETF's likely return to new shareholders in the coming years, based on historical profitability over the business cycle, current valuations, and fund expenses.