Five Defensive ETFs To Own When The Market Corrects

by on February 10, 2010 | ETFs Mentioned:

Still scarred by memories of the not-so-distant recession, many investors have been spooked by recent volatility in equity markets, wondering if they should bail on the market before another double dip. But even fresher are the memories of the bull market of 2009, especially for those who regretfully watched from the sidelines as equity markets soared. The psychological battle between fear of loss and anxiety over the potential regret of missing out on another rally plays out differently for different investors. Some will run for the exits, while others decide to stay the course. Many more land somewhere in the middle, looking for a way to reduce downside risk while maintaining significant exposure to another uptick in asset prices.

Below, we take a look at five defensive equity ETFs that have historically delivered strong relative performances during times of economic turmoil. For investors looking for a middle ground, these funds may be an efficient way to reduce volatility while maintaining significant upside exposure as well (for more actionable ETF ideas, sign up for our free ETF newsletter):

Claymore/Sabrient Defensive Equity Index ETF (DEF)

As its name suggests, this ETF invests primarily in “defensive” stocks that tend to perform relatively well during economic downturns. The index underlying this fund is designed to actively represent a group of securities that reflect occurrences such as low relative valuations, conservative accounting, dividend payments and a history of out-performance during bearish market periods. Not surprisingly, DEF has its largest weightings in the utilities and consumer staples sectors.

Utilities Select Sector SPDR ETF (XLU)

Utilities have historically been one of the least volatile sectors of the U.S. economy, as evidenced by this ETF’s relative to the S&P 500 of just 0.60. Most utilities companies provide essential services, meaning that revenue is relatively inelastic and profitability varies little between bull and bear markets. Major holdings in XLU include electric utilities, independent power producers, energy traders, and gas utilities.

XLU is only one of several utilities ETFs available to investors (see a complete list here). ETFdb Pro members can read more about drivers of utilities ETFs and read fund recommendations in the ETFdb Category Report (if you’re not a Pro member yet, sign up for a free trial or read more here).

Consumer Staples Select Sector SPDR ETF (XLP)

The consumer staples industry is another low-beta sector that focuses on stocks of companies that sell essential items and services. This ETF includes companies selling food and beverages, household products, tobacco, and personal products, and major components include Proctor & Gamble, Wal-Mart, and Phillip Morris International.

XLP outperformed SPY by about 15% during the recent recession, and has a beta relative to the S&P 500 of less than 0.50. See a complete list of consumer staples ETFs, including funds with a global focus, here.

PowerShares Dynamic Food and Beverage Portfolio (PBJ)

This cleverly-named ETF is a more targeted variation on traditional consumer staples funds, investing primarily in U.S. companies principally engaged in the manufacture, sale, and distribution of food and beverage products, agriculture products, and products related to the development of new food technologies. PBJ is linked a PowerShares Indellidex benchmark that evaluates potential components on a variety of investment merit criteria, including fundamental growth, stock valuation, and investment timeliness.

Market Vectors Gold Miners ETF (GDX)

During the most recent downturn, GDX was one of the best performing equity ETFs, boosted by rising gold prices as investors flocked to safe havens. Because domestic equity markets and gold bullion generally move in opposite directions, GDX has the potential to lessen the blow to investor portfolios during a downturn. It should be noted that the relationship between gold mining stocks and broader equity markets isn’t always an inverse one: GDX plummeted in January as both gold prices and domestic stocks lost ground. See this complete guide to gold ETFs for other ways to access gold bullion through ETFs.

Quick Look Back

Between September 2008 and the bear market lows in March of the following year, each of the ETFs profiled above lost value, with some declining by as much as 40%. But all of these funds outperformed SPY by at least 500 basis points during that period, with an average outperformance of 15% (10% excluding GDX).

Low Beta ETFs

These ETFs aren’t a silver bullet during economic downturns. During the next recession, these funds will likely lose value, and could drop significantly. But they will generally offer lower volatility than the broad market while still allowing investors to participate in an upside.

Disclosure: No positions at time of writing.