How to Play Defense During Bull Markets

by on October 27, 2014 | Updated December 8, 2014

When equity markets are charging ahead, one of the toughest challenges for investors is being able to shift gears when volatility enters the picture. Furthermore, realizing that sometimes a defensive position is needed during a bull market is often difficult, given the desire to lean towards riskier securities to maximize gains. For those looking for ways to play defensive during bull markets, we highlight several ETFs that can act as a buffer during volatile times [see also How Well Do Defensive ETFs Actually Work?].

Defensive Sector Rotationpowerlines

One of the most popular ways to implement a defensive position is to rotate a portfolio’s equity holdings towards defensive sectors, which include utilities equities and consumer staples. The investment thesis behind these two sectors is quite simple: both utilities and consumer staples companies provide goods and services that are inelastic, meaning no matter what the current market environment is, there will always be demand for these products [see Controlling Risk with ETFs]. 

The three most popular consumer staples ETFs include:

  • Consumer Staples Select Sector SPDR Fund (XLP)
  • Vanguard Consumer Staples ETF (VDC)
  • First Trust Consumer Staples AlphaDEX Fund (FXG)

 XLP and VDC are two of the cheapest ETF options; the funds charge 0.16% and 0.14%, respectively. VDC is also available commission free on Vanguard’s platform. XLP and VDC’s top 10 holdings are almost identical, with big names such as Procter & Gamble, Coca-Cola, Wal-Mart, and Philip Morris International given significant weightings. VDC, however, has a portfolio that is twice as large as XLP with just over 100 individual holdings.

First Trust’s FXG is also an intriguing option for those that want to veer away from traditional cap-weighted indexes. The fund’s underlying index employs a proprietary stock selection methodology that relies on factors including: three-, six- and 12-month price appreciation, sales to price and one year sales growth, book value to price, cash flow to price and return on assets. 

Utilities equities are also highly valued for their defensive characteristics – the three largest utilities ETFs include:

  • SPDR Utilities Select Sector Fund (XLU)
  • Vanguard Utilities ETF (VPU)
  • Dow Jones US Utilities Sector Index Fund (IDU)

In addition to being one of the best performing sectors during volatile periods, utilities are also ideal as a core holding for traditional buy-and-hold investors. These securities offer stable returns as well as an attractive source of income. The three funds listed above all offer an annual dividend yield of over 3.00%. Furthermore, the ETFs’ underlying companies are those that are able to consistently pay out to shareholders, and are also securities that can afford to increase these payments over the years.

Low Volatility ETFsVolatility

If you do not want to be overweight in a particular sector, investing in low-volatility ETFs is another viable option for a defensive play. These funds use unique screening methodologies to isolate those securities that have exhibited the lowest levels of volatility relative to the broader market [see also 3 Things You Need To Know About Low Volatility ETFs].

Investors should note, however, that these funds do not necessarily perform “well” during volatile periods; instead, these products are designed to minimize downside risk, meaning they will likely fall alongside broader equity markets, but not as much. Conversely, during bullish sessions, these funds typically underperform the broader market. 

Some of the most popular low-volatility equity funds, which offer exposure to both domestic and foreign markets, are:

  • S&P 500 Low Volatility Portfolio (SPLV)
  • MSCI USA Minimum Volatility Index Fund (USMV)
  • MSCI Emerging Markets Minimum Volatility Index Fund (EEMV)
  • MSCI All Country World Minimum Volatility Index Fund (ACWV)
  • MSCI EAFE Minimum Volatility Index Fund (EFAV)

Quant-Based Defensive ETFsbull bear

There are also several ETFs available for investors that are designed to dynamically shift holdings towards specific corners of the market depending on the current environment. Two of these funds are QuantSharesU.S. Market Neutral Anti-Beta Fund (BTAL), and Guggenheim‘s Defensive Equity ETF (DEF).

BTAL tracks an index that is equal weighted, dollar neutral and sector neutral. The index rebalances each month in an attempt to remain neutral in the current market environment. To obtain this objective, BTAL takes long positions in the lowest beta stocks and takes short positions in high beta stocks. The idea being that high beta stocks are more risky than their low beta counterparts, allowing the fund to cash in on any volatility in the riskier holdings while having the added benefit of holding key blue chips in its portfolio. Investors should note, however, that the fund’s unique strategy does come with a higher price tag: BTAL charges an expense ratio of 0.99% [see ETF Spotlight: U.S. Market Neutral Anti-Beta Fund (BTAL)].

DEF also offers exposure to a unique investment strategy that is designed to scale back beta and volatility. Its underlying index seeks to identify stocks that have a history of performing well, relative to broad equity benchmarks, during periods of escalated uncertainty. This ETF utilizes a variety of factors to determine allocations, such as focusing on stocks with low relative valuations, conservative accounting, dividend payments, and a history of outperformance during bearish market periods.

The Bottom Line

No matter which ETF play you use, it is always key to realize when it is necessary to take a defensive position in your portfolio, even during a bull market. Each of these ETF options are designed to mitigate downside risk during volatile periods or a market correction; however, we advise investors to dig down deep to determine which fund best aligns with your portfolio’s risk/return profile. 

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Disclosure: No positions at time of writing.