Two Funds for Cautious Investors

12/03/2009 12:00 pm EST

Focus: FUNDS

Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

Richard Lehmann, editor of ISA ETF Investor, says the market is in a precarious state, and he recommends two defensive funds that provide some downside protection.

This month the market looks a lot like last month—the Dow Jones Industrial Average hitting new highs and company revenues decreasing while earnings improve. The profitability is because companies are cutting expenses and thus earning more with less revenue.

While this is good for short-term profits, it is a finite solution and wreaks havoc with the unemployment rate since the expenses being cut are workers. Continued unemployment can’t be good for consumer spending. We think the current market is precarious and recommend funds that will do better in a possible downturn while still doing well if the market continues to improve.

The buy-write strategy still seems the best way to deal with an uncertain market. (Buy-write funds use “covered calls”—buying a security while selling calls in the same asset—to hedge their long positions and give some downside protection—Editor.)

We looked at all such funds and find that last month’s recommendation is still good. The Madison Strategic Sector Premium Fund (NYSE: MSP) is still trading at a discount [to net asset value of around 12%]. The fund yields [over 9%], which also helps moderate losses in case of a market downturn. (It closed above $12 Wednesday—Editor.)

The buy-write strategy will lessen returns in a sharply rising market and moderate losses in a market decline. They do best in a volatile yet sideways market. This fund still has the greatest discount and highest yield of the closed-end buy-write funds.

The inflation hypothesis is still going strong, and we are always looking for ways to moderate its effect through our recommendations. One good thing about an inflationary environment is that it’s easier for companies to raise prices.

The consumer, despite unemployment and fear of future economic conditions, still needs certain products. These are known as consumer staples. The companies in this sector will still have a steady market for their goods, even though the economy may be shrinking. Consumer discretionary items, on the other hand, can be sacrificed in hard times, so avoid them.

The Vanguard Consumer Staples ETF (NYSEArca: VDC) invests in a non-managed index of manufacturers and distributors of food, beverages, and tobacco, as well as producers of nondurable household goods and personal products. This ETF, like most of Vanguard’s offerings, has a very low expense ratio—in this case, only 0.2%. It has the largest concentration of holdings in household products at about 20.9%, followed by soft drinks at about 17.8%.

The fund’s ten largest holdings account for 62.7% of total net assets. The fund trades at [about] $68 and yields 1.8%. The yearly high and low range between $46.55 and $68. Procter & Gamble (NYSE: PG) and Wal-Mart Stores (NYSE: WMT) make up 22% of their holdings.

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