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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.

Does Your Portfolio Need A Defensive ETF?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 (NYSEARCA: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 (NASDAQ:RRD) (a provider of communications services) and Avery-Dennison (NYSE: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 (NYSEARCA: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.

Source: The Case for a Defensive Equity ETF