The Defensive Sector Equity ETF Portfolio

While examining the holdings of the Invesco S&P 500 Low Volatility ETF (SPLV), I noticed a significant overweight in consumer staples, utilities, and healthcare compared to the broader S&P 500 index.

For those of you unfamiliar with SPLV, the ETF aims to mitigate equity market fluctuations by holding the 100 least volatile stocks from the S&P 500 (based on one-year trailing beta), rebalanced quarterly.

Despite its intent to offer a smoother investment experience (which it historically has), the ETF's 0.25% expense ratio seems a bit costly for what it accomplishes.

This sparked my curiosity—could I assemble a less expensive, low-volatility equity portfolio using sector-specific ETFs? Here's my approach to creating that alternative.

Why defensive sectors?

State Street SPDR ETFs have conveniently done most of the legwork here—they provide an insightful pamphlet that illustrates the resilience of the three defensive sectors. According to their analysis:

"Since 1999 [to 2022], there have been 11 times the S&P 500 has pulled back by 10% or more during a calendar quarter. During those occurrences, as the chart shows, an equally weighted portfolio of defensive sectors (Consumer Staples, Health Care, and Utilities) has significantly outperformed the S&P 500. Further, the defensive sectors portfolio fared better than the Russell 1000 Value Index, outperforming in nine of the 11 quarters."

This isn't surprising when you consider the attributes of mega-cap companies in sectors like healthcare or consumer staples. Companies such as Johnson & Johnson (JNJ) and Procter & Gamble (PG) exhibit characteristics like double-digit margins, high return on equity, low earnings variability, and low beta.

These traits reflect the inherent stability of their markets and consistent consumer demand, which shields them during economic downturns.

However, I remain cautious about utilities. Much of the historical performance data were compiled during a period of generally falling interest rates, which benefited these typically debt-heavy companies.

In 2022, when interest rates rose, utility stocks underperformed and failed to provide downside protection due to their rate sensitivity. Unlike staples and healthcare, utilities benefit from regulated demand but don't necessarily boast robust margins or balance sheets.

Additionally, the 'utility death spiral'—where utilities must continually invest in infrastructure amidst rising operational costs and fixed regulatory returns—and risks from climate change and disasters are ever-present concerns. I don't think utility investors are compensated adequately for these risks.

The ETFs to buy

The main ETFs to consider are Consumer Staples Select Sector SPDR Fund (XLP), Health Care Select Sector SPDR Fund (XLV), and Utilities Select Sector SPDR Fund (XLU)—all issued by State Street and tracking consumer staples, healthcare, and utilities sectors of the S&P 500, respectively.

These ETFs are market-cap weighted with a focus on mega caps, are among the cheapest with a 0.09% expense ratio, and very liquid with a minimal bid-ask spread. If you're into options for hedging or speculation, the Select Sector ETFs are your best bet too,

For those interested in including mid- and small-cap stocks outside of the S&P 500, Vanguard offers alternatives like Vanguard Consumer Staples ETF (VDC), Vanguard Health Care ETF (VHT), and Vanguard Utilities ETF (VPU) for just 0.1% expense ratio.

Finally, for global diversification, iShares provides iShares Global Consumer Staples ETF (KXI), iShares Global Healthcare ETF (IXJ), and iShares Global Utilities ETF (JXI). These have wider spreads and higher fees at 0.41%, and I'm generally less enthusiastic about these due to the cost and liquidity concerns.

Putting the portfolio together

I stuck with XLP, XLU, and XLV for simplicity and their low fees, and here’s how this combination performed versus SPLV from May 5, 2011, to September 13, 2024.

This defensive trio achieved higher Compound Annual Growth Rate (CAGR), lower maximum drawdown, slightly lower standard deviation, and a better Sharpe ratio, outperforming SPLV in every single dimension.

But how does this compare against the benchmark SPDR S&P 500 ETF (SPY) from 1998? This longer backtest allows us to assess the defensive three-sector portfolio through major market events like the dot-com bubble, the 2008 financial crisis, and the COVID-19 pandemic.

To my pleasant surprise, the portfolio not only provided a slightly higher total return compared to SPY but also exhibited markedly lower maximum drawdown and standard deviation, alongside a significantly better Sharpe ratio.

This performance underlines that sectors indeed have discernible, concrete, repetitive, and testable characteristics during different parts of the economic cycle.

Although the sectors in this portfolio—healthcare, consumer staples, and utilities—don’t deliver the dramatic returns of tech, they tend to lose less during downturns. Over the long term and through various market crises, this defensive strategy has proven to be a winning combination.