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Just because an ETF has ‘Defensive’ in the name doesn’t mean it will prove to be defensive during a bear market or a period of rising volatility.
There are several approaches to selecting defensive stocks. Some seem to make sense but are actually unproven. Others are based on what has happened in the past, with no guarantee that that’s how things will play out the next time around.
Sectors, Volatility, and Risk
For starters, certain sectors are regarded as defensive because they are not closely correlated to economic cycles. The healthcare, utilities, defense and consumer non-discretionary sectors are all regarded as defensive. The problem with that approach is that these sectors all have cycles of their own, and can run into their own hurdles.
The US utilities sector, as an example, was down 6 percent in December after the US tax reform bill was signed. There is no point exchanging one type of risk for another.
Another approach is to select stocks with low volatility. This approach can also be flawed at times – risk and volatility are no the same thing. And, periods of low volatility can precede periods of high volatility. Picking stocks with low volatility may not prove to be a very defensive strategy.
Under different circumstances, it may be worth considering other asset classes, but right now there just isn’t much point owning bonds or real estate. Gold can reduce portfolio volatility, but there isn’t a reason to own it beyond that. There’s no holy grail when it comes to picking defensive stocks or sectors.
The best one can do is use a general approach combining multiple factors and common sense. For further safety, one can then diversify across two or three ETFs that take a slightly different approach to the problem. The following ETFs each offer a slightly different approach to selecting stocks that should hold up well if we see a market downturn in 2018.
For Low Market Correlation: Guggenheim Defensive Equity ETF Fund (DEF)
Expense ratio 0.60% | Asset under management: $188 million
Number of holdings: 101 | Largest holding: 1.05% | Download Factsheet
The Guggenheim Defensive Equity fund tracks the Sabrient Defensive Equity Index. This index uses a rule-based process to identify stocks with strong balance sheets, consistent dividend payments and a history of performing well during periods of market weakness. The selection process also rules out companies that engage in risky accounting practices.
Rather than investing in stocks or sectors that are simple accepted to be defensive, the selection process identifies stocks that have actually proved their mettle during recent corrections.
The fund holds 100 stocks which are equally weighted. That is fairly concentrated for a defensive fund, but implies every stock is there for a reason.
High Annual Fee
Yes, the annual fee of 0.6% is relatively high, but you are paying for a unique approach to identifying defensive stocks.
One of the problems with stocks widely regarded as defensive, is that too many funds buy them for their defensive qualities, leaving them overbought and overvalued. This fund holds a number slightly obscure stocks which haven’t been overhyped for their defensive attributes. Examples include Perkin Elmer, Scripp Networks and Progressive Corp.
The fund is well diversified across sectors with no single sector accounting for more than 20 percent.
For Profitability and Low Leverage: iShares Edge MSCI USA Quality Factor ETF (QUAL)
Expense ratio 0.37% | Asset under management: $4.3 billion
Number of holdings: 126 | Largest holding: 4.98% | Download Factsheet
iShares’s Quality factor ETF takes a very different approach to select robust stocks.
While the strategy doesn’t necessarily seek out purely defensive stocks, it only invests in high quality stocks, which should prove defensive during periods of market weakness. Where the Guggenheim fund takes a backward-looking approach to select defensive stocks, this fund uses fundamental factors which identifies stocks with strong cash flows, high return on equity and low levels of debt. No attention is paid to the stock’s price performance, however, during periods of volatility investors tend to look for companies with low debt and strong cashflows.
The fund holds 126 stocks, ten of which account for 34% of the fund. The fund is, therefore, more concentrated in the stocks it rates the highest. However, a quick look at the top five holdings (Apple, Altria, J&J, Mastercard and 3M) shows the fund isn’t concentrated on a single theme.
That’s a good thing when trying to be defensive.
High Exposure To The Tech Sector
While the fund does have quite high exposure to the tech sector (24%), that exposure is in the most profitable companies which aren’t trading at excessive multiples. Apart from Apple, the largest tech holdings are IBM, Nvidia, and Texas Instruments, all of which are reasonably priced relative to their earnings growth.
The tech sector aside, this ETF is spread across all market sectors. Large caps account for 89 percent of the fund, with the remaining 11 percent is in mid-cap stocks.
For Global Diversification: PowerShares FTSE RAFI Developed Markets ex-US (PXF)
Expense ratio 0.37% | Asset under management: $1.2 billion
Number of holdings: 1016 | Largest holding: 1.69% | Download Factsheet
This fund is PowerShares’ offering for a fund weighted by fundamentals rather than market capitalization. It’s invested only in developed markets outside of the US.
Fundamental indexing seeks to reduce the risk inherent in market cap weighted indices. They do this by reweighting an index using a blend of metrics including aggregate earnings, sales, book value, dividends, and a number of employees. By doing so, the companies within an index are weighted by a more general reflection of their size – rather than relying entirely on the value given to each company by the market. That means companies that dominate most indices due to their growth and price momentum will have a reduced weighting. During bear markets and corrections, it’s usually the high-flying growth stocks trading on high multiples that fall the most.
This fund holds 1016 stocks that are listed on the exchanges of developed markets outside of the US. All the companies are large and midcap, and they are weighted according to several fundamental measures. This allows US investors to diversify away from US companies, without exposing them to emerging markets or small caps.
The fund is well diversified by region, country and sector. Japan accounts for 21 percent of the fund, the UK 15 percent and France and Germany 10 percent each. Twelve other countries account for the remainder of the fund. The allocation to financial services is 27 percent which would be a concern if the fund only invested in one country – but in this case that risk is spread across 16 banking systems.
We can never be sure what the future will hold, and we can never really be sure how defensive any particular stock or strategy will be during a bear market. The three funds listed above offer three different approaches to seek out defensive stocks. While nothing is certain, there are logical reasons to each of these approaches, and the blended approach should avoid and disappointing surprises.