The Case for a Defensive Equity ETF

Following a furious market rally that has seen major market indexes rise more than 50% from their March lows, some investors are beginning to worry that stock prices have run ahead of fundamentals, and that the recovery we’ve seen to date is too good to be true.

A closer look at the “good news” that has driven up stock prices in recent months is worrisome. Unemployment continues to rise (albeit at a slower pace) and the dollar continues to slump against major rival currencies. Many investors, including one who called the current downturn in 2006, believe the worst is yet to come.

The road ahead for the U.S. economy includes a potential commercial real estate bust, the monetary consequences of the massive stimulus plans still in progress, and continually strained relations with major trading partners. Yet there are undoubtedly signs of hope as well, including increased consumer confidence and strength in Asian economies.

To say the current economic environment is an uncertain one is like saying that Bernie Madoff’s business practices were questionable. Investors concerned about a “double dip,” but also fearful of watching a continued recovery from the sidelines may want to take a look at a defensive equity ETF.

The Claymore/Sabrient Defensive Equity Index ETF (DEF) has nothing to do with the aerospace and defense sector – rather it offers exposure to equities that tend to perform relatively well in economic downturns. The index underlying this ETF is comprised of about 100 stocks selected to represent a group of securities that maintain low relative valuations, conservative accounting, high dividend payments, and a history of out-performance during bear market periods.

As might be expected, DEF maintains significant allocations to companies operating in the utilities (24%), consumer staples (20%), and health care (17%) industries. These sectors of the economy tend to see stable demand for their products, particularly relative to more volatile areas like consumer discretionary and technology, which can see drastic changes in demand in different economic environments.

DEF’s largest holdings at present are RR Donnelley (RRD) (a provider of communications services) and Avery-Dennison (AVY) (a producer of office and consumer products). And DEF is reasonably-well diversified, as none of the ETF’s 100 holdings accounts for more than 1.5% of total assets.

DEF’s holdings aren’t quite counter-cyclical – the ETF lost value during the most recent recession just as most equity securities did – but it did soften the blow for many investors. From the beginning of 2008 to the bear market lows in March of 2009 (at least what we hope were market lows), DEF lost a little more than 45%, while the more broad-based S&P 500 SPRD (SPY) declined by 53%. The flip side of the coin is that defensive equities may experience less price appreciation when the markets turn and head upward. Since bottoming out in March, DEF has gained about 43%, compared to 57% for SPY.

The moral of the story is that not all equity ETFs are created equally, and investors looking to reduce the risk and volatility of their portfolios don’t necessarily need to turn to Treasury funds to do so.

For those who are uneasy about the market’s prospects over the next 12 months but dread the feeling of regret associated with missing out on a bull run, DEF may be a way to hedge your bets, keeping your assets in equities while simultaneously reducing beta.

Disclosure: No positions at time of writing.

Comments

[Joseph L. S...:]

"The moral of the story is that not all equity ETFs are created equally, and investors looking to reduce the risk and volatility of their portfolios don’t necessarily need to turn to Treasury funds to do so."

...No, but I don't think an ETF that "only" plummets 45% when the broad market is down 53% is much of an answer! Especially since it only regained 43% to the market's 57%. Instead, a concerned investor might consider inverse ETFs, precious metals, MLPs, bond funds and a plethora of other contra investments that have done much better than this...

Sep 21 11:04 AM

[Geoffrey Lordi:]

Agreed, Joe.

Another part of the problem with DEF is its horrific volume. With spreads like this, and no takers on either side of the aisle, an otherwise reasonable strategy could end the day so far off that comparing its performance over the short- and intermediate-terms proves largely irrelevant.

And, technically speaking, prescient investors - or traders - weren't necessarily looking for uber-defensive plays following the March lows as so much had already been choked from folks' accounts. To wit: the S&P outperformed DEF by 11% in the froth back up, and Vanguard's all-world, ex US, pummeled DEF to the tune of 40%.

I think the idea of this ETF wasn't bad, but I think tracking, volume, and competition make it a nondescript choice.

Sep 21 11:17 AM

[Mad Hedge F...:]

Why not bonds? A number of readers have asked me to come up with a safe, high yielding investment in which to hide out in case the equity markets swoon again. That means they are looking for a security that offers a high fixed return, denominated in a strong currency that will benefit from future upgrades that will boost the principal over time. All of that is another name for the Invesco PowerShares Emerging Market Sovereign Debt ETF (PCY). The fund has 40% of its assets in bonds issued in Latin America and 31% in Asia, with the bulk of the maturities exceeding ten years. The two year old fund now boasts $340 million in market cap and pays a handy 6.42% dividend. This beats the daylights out of the nine basis points you currently earn for cash, the 3.40% yield on 10 year Treasuries, and still exceeds the 6.42% dividend on the iShares Investment Grade Bond ETN (LQD), which buys predominantly single “A” US corporates. The big difference here is that foreign bonds are issued in strong foreign currencies instead of weak dollars, and have a rosy future of further credit upgrades to look forward to. It turns out that many emerging markets have little or no debt because until recently, investors thought their credit quality was too poor. No doubt a history of defaults in Brazil and Argentina in the seventies and eighties is at the back of their minds. With US government bond issuance going through the roof, the shoe is now on the other foot. A price appreciation of 125% over the past year tells you this is not exactly an undiscovered concept. Still, it is something to keep on your “buy on dips” list.

Sep 21 11:40 PM

[absolute re...:]

I think DEF serves the purpose well you are describing. The low volume seems irrelevant to me as I understand this it tracks an index and has the underlying value of those stocks. If you don't feel you are getting a fair shake in the trading you can always request the underlying stocks (I think). So, while the last trade may not reflect the current value the ETF should trade as the index is valued. As I understand the purpose of this Claymore ETF it is intended to help in down markets so the fact that something else outperformed it in an up market seems like that isn't apples to apples. I, myself, bought the Claymore NFO which tracks the SBRIN. This one is for quality stocks using a Insider Buying sentiment. It has outperformed the S&P and most any other Claymore ETF as it is up nearly 100% since the March lows. I personally like the idea of hedging my investments as I have not a clue which way the market will go so in short I enjoyed your article.

Thanks.

Sep 25 01:54 PM