Defensive sector funds are mutual funds or exchange-traded funds (ETFs) that invest in companies in recession-proof industries. These industries are called defensive sectors because they tend to stay stable whether the market is healthy or not. Investors can use them to defend against major spikes and drops that may affect other parts of their portfolio.
Understand how defensive sector funds work and how you can work them into your investment strategy to preserve the value of your portfolio in hard times.
- A defensive sector fund is one that primarily invests in firms in recession-proof or "defensive" sectors.
- These funds can defend against large decreases in share prices and portfolio value during market corrections or bear markets
- Consumer staples, health care, telecommunication services, utilities, and certain commodities are examples of defensive sector industries.
- When investing in these funds, avoid putting all your money in one sector and instead aim for diversification in the sectors and sub-sectors you invest in.
What Are Defensive Sector Funds?
Defensive sector funds refer to mutual funds or ETFs that mainly (or only) invest in the stock of companies that tend to remain stable through all phases of the economic cycle.
By contrast, cyclical sectors depend highly on the economic cycle. (Think financial services, luxury goods, and other things people won't buy as often when money is tight.) So, unlike cyclical sectors, non-cyclical sectors like health care tend to produce stable profits through all phases of the economic cycle. Such companies produce goods or offer services that consumers will buy no matter the state of the market. Staples like food, health care, and utilities are just a few of the many types of industry that a defensive sector fund might invest in.
But this is just one factor in building a defensive sector fund. "Defensive" stock can be found in many types of industries if the firm has strong earnings, innovation, pricing power, and a track record of disrupting the status quo.
- Alternate name: defensive stock funds
How Defensive Sector Funds Work
When they suspect the economy is headed for a decline, many investors begin to pad their portfolios with defensive sector funds. These funds are referred to as "defensive" because they tend to maintain their earnings and profits during market downturns. This allows them to perform better than the broader market during a market correction or during a bear market.
A market correction occurs when the market declines of between 10% and 20%; while a bear market features declines of 20% or more (and may come with a recession). When you invest in defensive sector funds, your main goal is to defend against major decreases in share prices that might occur during these events.
For instance, during tough times, consumers will reduce spending on luxury items, such as entertainment, travel, and high-end clothing, and buy only the things they need, like food, health care services, and basic utilities. If you buy defensive stock funds that invest in industries like these, your holdings should, in theory, decline less than others. The assets that make up your fund are stocks that should remain mostly steady in price during a market decline.
While defensive sectors remain mostly stable in price throughout the economic cycle, the trade-off is that they offer less drastic growth during market upswings, as compared to higher-risk, cyclical industries.
Types of Defensive Sector Funds
These funds invest in industries that include:
- Consumer staples: Consumer staples, also known as consumer non-cyclical stocks, are tend to maintain more price stability in a down market than cyclical stocks. During an economic decline, consumers still need staples, such as cereal and milk, and may even increase their use of so-called "sin stock" products, such as cigarettes and alcohol. Knowing this, some investors buy defensive sector funds such as Vanguard Consumer Staples ETF (VDC) when they think a recession will occur.
- Health care: This broad defensive sector includes hospitals and other health care facilities, 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 still need to buy in hard times. After all, health is a prime concern, and people still visit doctors and refill their prescriptions when they can't afford other goods. Vanguard Health Care (VGHCX) is an example of a mutual fund in this sector.
- Telecommunication services: This sector includes companies that offer communication services through cellular, fiber-optic, fixed-line, wireless, and high-bandwidth networks. Their business follows known patterns through each phase of the economic cycle, and thus tends to preserve their value as the economy moves into a recession. Fidelity Select Communication Services Portfolio (FBMPX) is one such mutual fund that grants investors exposure to this sector.
- Utilities: People depend on gas, electricity, water, and other utilities in daily life. Utility stocks include companies that produce or deliver these services. They are 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. Vanguard Utilities ETF (VPU) is an example of this kind of defensive sector fund.
- Certain commodities: Commodities include crude oil, coal, corn, tea, rice, gold, and silver. Not all of these basic goods are defensive by default, but some are able to maintain stable prices during an economic decline. For instance, gold has historically produced a high return amidst economic volatility because many investors see it as a safer alternative to stocks . Fidelity Select Gold Portfolio (FSAGX) is an example of a mutual fund that targets the commodity of gold.
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.
How To Invest With Defensive Sector Funds
You can purchase defensive sector mutual funds or ETFs through a brokerage or investment firm. But before you bring these funds into your portfolio, figure out your asset allocation, or how your money will fall into different asset classes like stocks and bonds. Then, set up the portion of your portfolio that each asset class should represent so that your choice of stock does not overweight the overall scheme.
When picking mutual funds or ETFs for your portfolio, strive for diversification in your choice of stocks from the sectors and sub-sectors. For instance, health care 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.
By contrast, if you spread your money between funds in the health care, consumer staples, utilities, and telecommunications sectors, this can provide greater diversification. This in turn guards against drastic declines in your portfolio that would happen if one defensive industry declines. This is because not all of these industries will go up or down in price in the same types of economic conditions.
Likewise, avoid funds that overweight a single sub-sector. For instance, biotechnology is an attractive sub-sector of the health sector because of its movement; this is a field with constant innovation. But if a fund invests in this sub-sector and no others, a decline in the sub-sector could result in 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 make for less severe losses during a downturn.
Are Defensive Sector Funds Worth It?
Defensive stock funds can reduce 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.