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The last several years have been challenging to average retail investors. Many are looking to lower risk, particularly those with shorter time frames or near retirement. Although market timing, hedging, inverse indexing and use of put and call options are considered and utilized by some, many investors would prefer not to become short term traders or get too complex in their portfolio management. There is much evidence that there are advantages to holding low beta stocks that pay dividends, but even this can be riskier than buying the industry or sector, because of lack of diversification and single company risk.

So which sector or sectors should be considered when becoming defensive? The defensive sectors usually thought of include utilities, consumer staples, and health care. All are good choices. Utilities, it should be noted, despite a great 2011, as a whole were hammered in 2008 and had a mediocre bounce back in 2009.

Utilities ETF/Symbol/2008/2009/2010/2011Annual Returns

Utilities SPDR

XLU

-29.15

11.67

5.35

19.53

Vanguard Utilities

VPU

-27.92

11.27

7.05

18.89

Ishares US Utilities

IDU

-30.01

12.06

7.21

18.6

As of 5/31/12, XLU, VPU, and IDU had YTD returns of .59, .14, -.07.

Consumer Staples held up much better in 2008, and had good annual returns in 2009, 2010, and 2011.

Consumer Staples ETF/Symbol/2008/2009/2010/2011Annual Returns

Consumer Staples SPDR

XLP

-14.8

14.21

13.81

14.06

Vanguard Consumer Staples

VDC

-16.71

16.55

14.62

13.6

Ishares US Consumer Goods

IYK

-26.02

23.22

18.99

8.38

As of 5/31/12, XLP, VDC, and IYK had YTD returns of 4.52, 4.48, 4.66.

Health care sector ETFs also fared fairly well on an annual basis with less losses than the general market in 2008 and market beating returns in 2011, just as utilities and consumer durables.

Health Care ETF/Symbol/2008/2009/2010/2011Annual Returns

Health Care SPDR

XLV

-23.1

19.48

3.32

12.37

Vanguard Health Care

VHT

-23.9

21.8

5.6

10.7

Ishares US Health Care

IYH

-22.97

21.07

4.13

11.23

As of 5/31/12, XLV, VHT, and IYH had YTD returns of 4.73, 6.27, 5.79.

So, by simply looking at annual returns, the top defensive sector with fairly consistent returns would be the Consumer Staples sector. Well, yes in a broad sense. To broaden our horizons, however, it would be beneficial to drill down to the sub sector level. One worthwhile sub sector to consider is pharmaceuticals. Pharma ETFs held up well in 2008, with consistent market beating returns the last 3 years.

Pharmaceutical ETF/Symbol/2008/2009/2010/2011Annual Returns

Pharmaceutical SPDR

XPH

-9.01

27.6

22.47

12.37

PowerShares Dyn. Pharma

PJP

-10.67

16.85

27.51

19.99

Ishares US Pharmaceutical

IYE

-14.91

30.06

12.72

20.91

As of 5/31/12, XPH, PJP, and IYE had YTD returns of 8.53, 9.47, 6.52.

Well, since the numbers look good for this group, why not pick a good dividend paying pharmaceutical stock instead? Stock selection skills would have to play a big part to be successful. Lets take 3 well known companies that get a large part of their revenue from pharmaceuticals.

Pharmaceutical Stock/Symbol/2008/2009/2010/2011Annual Returns

Pfizer

PFE

-16.45

7.23

0.22

28.16

Johnson and Johnson

JNJ

-7.61

10.88

-0.7

9.67

Merck

MRK

-45.07

25.2

2.79

8.93

As of 5/31/12, PFE, JNJ, and MRK had YTD returns of 3.1, -3.0, .8.

These 3 stocks are widely known and widely held. In fact, all three of the aforementioned Pharmaceutical ETFs hold these stocks,with the iShares Pharmaceutical ETF having the above stocks as the top 3 holdings, comprising nearly 26% of the portfolio. Seems obvious from where I look that picking a diversified sector ETF may be a safe choice for those looking for performance and some downside protection.

Source: Playing Defense With Sector ETFs