Why Defensive ETFs Fail In The Market Downturn?

U.S. economy has been on a rally since Donald Trump’s election victory. Trump’s tax reform was recently signed into law, increasing optimism among investors around a faster pace in economic growth and on the prospective passing of other policies of the President.

However, with better-than-expected job growth, investors are betting on faster rate rises and inflation, causing havoc in the markets. In such a situation, investors generally flock to traditional defensive investments. However, these investments failed to protect investors in the most recent downturn.

Market Correction

Per data released by the Labor Department, wages grew 2.9% year over year in January compared with 2.6% in the prior month, the highest pace since April 2009. This introduced fears among investors of rising rates and inflation making a comeback.

Moving on to interest rates, the Fed is widely expected to hike interest rates multiple times this year to tame inflation. Given this, markets are betting on the Fed to hike rates more than three times suggested earlier. Per the CME Fed Watch tool, there is a 71.9% chance of a 25 basis point rate hike in March (read: 6 Ways to Build a Rate-Proof Portfolio With ETFs).

As a result, the S&P 500 entered correction territory, as it declined more than 10% from the record high set in January. This spooked investors and weighed on their risk appetite, which in turn made investors reallocate their portfolios.

Defensive Funds in Detail

Low-volatility ETFs are the go-to investment vehicles during times of high market uncertainty. These investments fared well in 2017, as high political uncertainty and geopolitical risks brought low volatility plays in favor.

Low-volatility ETFs generally include utilities and staples stocks, and try to expose investors to high dividend yields. These funds invest in stocks that are viewed as “bond like” by investors for their steady business. Although this strategy is known to protect investors during uncertain times, the reason it did not work out in the recent selloff is that rising rate expectations were behind it. For instance, PowerShares S&P 500 Low Volatility Portfolio (SPLV) has lost 5.8% so far in February.

High dividend funds are known to be negatively correlated to rising rates. It is a good play to combat market uncertainty. However, with bond yields at record highs and the 10-year yield touching 2.81%, the appeal of bond-like equities declined. For instance, WisdomTree U.S. Quality Dividend Growth Fund (DGRW) has lost 6.3% so far in February.

As a result, it is no surprise that defensive funds failed to be in positive territory during the sell-off caused by fears over rising rates. As the Fed keeps on raising rates, these so called defensive investments might not be able to protect investors from the wrath of the correction. For instance, Utilities Select Sector SPDR Fund (XLU) has lost 4.7% so far in February while Consumer Staples Select Sector SPDR Fund has lost 5.6% in the period.

Let us now discuss a few ETFs focused on providing exposure to the discussed sectors.

PowerShares S&P 500 Low Volatility Portfolio SPLV

This fund is a popular ETF targeting large-cap U.S. companies with low volatility.

It has AUM of $7.1 billion and charges a fee of 25 basis points a year. From a sector look, the fund has high exposures to Financials, Utilities and Industrials with 20.9%, 19.7% and 19.2% allocation, respectively. The fund’s top three holdings are Honeywell International Inc (NYSE:HON) , Berkshire Hathaway (NYSE:BRKa) BRKB and Coca-Cola Co (NYSE:KO) with 1.3% allocation each. The fund has returned 11.2% in a year but has lost 3.3% year to date. It has a Zacks ETF Rank #3 (Hold), with a Medium risk outlook.

WisdomTree U.S. Quality Dividend Growth Fund (NYSE:D)

This fund seeks to provide exposure to large, established U.S. companies providing high dividends by applying quality screens. It has AUM of $2.0 billion and charges a fee of 28 basis points a year. From a sector look, the fund has high exposures to Information Technology, Industrials and Health Care with 20.2%, 18.7% and 17.5% allocation, respectively.

The fund’s top three holdings are Exxon Mobil (NYSE:XOM) , Johnson & Johnson (NYSE:JNJ) and Microsoft Corporation (NASDAQ:MSFT) with 5.0%, 4.6% and 4.1% allocation, respectively. The fund has returned 22.0% in a year but has lost 1.3% year to date. It has a Zacks ETF Rank #3, with a Medium risk outlook.

Consumer Staples Select Sector SPDR Fund XLP

This fund seeks to provide exposure to staples stocks and has AUM of $8.0 billion and charges a low fee of 13 basis points a year.

The fund’s top three holdings are Procter & Gamble (NYSE:PG) , Coca-Cola Co and PepsiCo Inc (NASDAQ:PEP) with 11.6%, 9.5% and 8.9% allocation, respectively. The fund has returned 3.9% in a year but has lost 4.6% year to date. XLP has a Zacks ETF Rank #4 (Sell), with a Medium risk outlook.

Utilities Select Sector SPDR Fund XLU

XLU is one of the most popular funds in the utility space. The fund has AUM of $7.3 billion and is a relatively cheaper bet as it charges a fee of 13 basis points a year. It has an 11.4% allocation to NextEra Energy (NYSE:NEE) , 8.0% to Duke Energy (NYSE:DUK) and 7.8% to Dominion Energy (NYSE:D) . The fund has returned 2.6% in a year but has lost 7.1% year to date. It has a Zacks ETF Rank #4, with a Medium risk outlook.

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