What Are Defensive Stock Funds?
Get Defensive With Robust Sector Funds
When the economy declines, many investors begin to pad their portfolios with defensive stock funds, also referred to as defensive sector funds.
These funds are referred to as "defensive" because they tend to maintain their earnings and revenues during market downturns, allowing them to perform better than the broader market during a market correction or a bear market accompanied by a recession. Understanding defensive stock funds and how to add them to your investment strategy can help preserve the value of your portfolio in hard times.
Basics of Defensive Stock Funds
Defensive funds are mutual funds or exchange-traded funds (ETFs) that primarily or exclusively invest in the stock of companies in recession-proof industry groups, called defensive sectors.
Unlike cyclical sectors like financial services, which are highly dependent on the economic cycle, defensive or non-cyclical sectors like health care tend to generate stable profits throughout all phases of the economic cycle. However, stock in firms in a variety of industries can be regarded as defensive if the firm has strong earnings, innovation, pricing power, and a track record of disrupting the status quo.
The basic idea of investing in defensive stock funds is to protect (defend) against significant decreases in share prices that occur during either market corrections, characterized by market declines of between 10% and 20%, or bear markets, featuring declines of 20% or more, and potentially, an accompanying recession.
For example, during difficult economic times, consumers typically reduce spending on luxury items, such as entertainment, travel, and high-end clothing, and buy only essentials, including food, health care, and basic utilities. If you buy funds invested in defensive industries like these, your holdings should, in theory, decline less dramatically since the underlying stocks should fluctuate less in price during a decline.
While defensive sectors remain relatively stable in price throughout the economic cycle, the trade-off is that they experience less dramatic growth during market upswings compared to higher-risk, cyclical industries.
Examples of Defensive Sectors
The main industry groups that are considered to be defensive include:
- Consumer staples: Consumer staples, also known as consumer non-cyclical stocks, are characterized as defensive because they tend to maintain more price stability in a down market than cyclical stocks like financial services companies or furniture manufacturers. During an economic decline, consumers still need staples, such as cereal and milk, and may even increase their consumption of so-called "sin stock" products, such as cigarettes and alcohol. Knowing this, some investors buy defensive stock funds in consumer staples when they believe a recession will soon occur.
- Health care: Even a person with no investing experience can identify firms in this broad defensive sector, including hospital conglomerates, insurance companies, drug and medical instrument manufacturers, and biomedical companies. Health care is a defensive sector because these companies offer products or services that consumers will likely continue to buy in difficult economic times. After all, health is a high priority, and people still visit doctors and refill prescriptions in hard times.
- Utilities: People depend on gas, electricity, water, and other utilities in day-to-day life. Utility stocks representing companies producing or delivering these services are considered defensive because consumers still need them during an economic decline. This fact makes the prices of defensive utility stock funds less sensitive to market fluctuations.
- Commodities: Commodities include crude oil, coal, corn, tea, rice, gold, and silver. Not all of these basic goods are defensive by definition, but they are viewed as defensive in the mid-to-late stages of the economic cycle and have the potential to maintain price stability during an economic decline. A commodity like gold may actually rise in price during an economic downturn because investors see it as a safer alternative to stocks or currencies.
During the Great Recession, the value of gold rose dramatically; the Producer Price Index for gold increased by 101.1% percent from 2008 to 2012.
Building a Portfolio With Defensive Stock Funds
Before you incorporate sector funds into your portfolio, determine your asset allocation, or the division of your money into different asset classes like stocks and bonds. Then, establish the percentage of your portfolio that each asset class should represent so that you do not overweight stock as a percentage of your overall portfolio.
When picking individual mutual funds or ETFs for your portfolio, strive for diversification in the sectors and sub-sectors represented in the fund. For example, commodities is a defensive sector. But if you invest all your money in it, your portfolio value will move up and down with price swings in that sector alone; no other sector would act as a hedge against losses in that sector. In contrast, spreading your money between funds in the health care, consumer staples, utilities, and commodities sectors can provide greater diversification and potentially less dramatic declines in your portfolio if any one defensive industry declines. This is because not all of these industries will go up or down in price in the same economic conditions.
Likewise, avoid funds that overweight a particular sub-sector. For example, biotechnology is an attractive sub-sector of the health sector because of its continual innovation. But if a fund is invested heavily in this sub-sector, a decline in the sub-sector could generate an outsized decline in the value of your holdings. Choosing defensive stock funds with holdings in a variety of sub-sectors in a given sector can minimize losses during a downturn.
The Bottom Line
Defensive stock funds can minimize risk and losses in the value of your portfolio during economic declines. But these funds can still lose value during a market correction or bear market. For this reason, defensive sector funds are most effective when you use them as one part of a diversified portfolio of mutual funds.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
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U.S. Bureau of Labor Statistics. "Gold Prices During and After the Great Recession," Page 2. Accessed March 24, 2020.
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