What Are Defensive Sector Funds?

Definition and Examples of 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 that people won't buy as often when money is tight.) Unlike cyclical sectors, non-cyclical sectors like health care tend to produce stable profits through all phases of the economic cycle. These companies produce goods or offer services that consumers will buy regardless of the state of the market or economy. Fundamentals like food, healthcare, and utilities are just a few of the many types of industries a defensive sector fund might invest in.

"Defensive" stocks can be found in many industries if the firm has strong earnings, innovation, pricing power, and a track record of disrupting the status quo.

• Alternate name: defensive stock funds, non-cyclical sector ETF

How Defensive Sector Funds Work

When investors suspect that the economy is headed for a decline, many begin to pad their portfolios with defensive sector funds. This allows them to perform better than the broader market during a market correction or a bear market.

A market correction occurs when the market declines between 10% and 20%. 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 significant decreases in share prices that might occur during these events.

During tough times, consumers will reduce spending on luxury items, such as entertainment, travel, and high-end clothing. Instead, they tend to buy only necessities such as food, healthcare services, and basic utilities. If you purchase defensive stock funds that invest in industries like these, your holdings should, in theory, decline less than others. That is because the assets that make up your fund are stocks that have historically remained steady in price during market declines.

Types of Defensive Sector Funds

Consumer-cyclical funds invest in several industries that historically maintain their value.

Consumer Staples

Consumer staples, also known as "consumer non-cyclical stocks," 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 they 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.

Healthcare

This broad defensive sector includes hospitals and other healthcare facilities, insurance companies, drug and medical instrument manufacturers, and biomedical companies. Healthcare 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 primary concern, and people still visit doctors and refill their prescriptions even when they can't afford other goods.

Telecommunication Services

This sector includes companies that offer communication services through cellular, fiber-optic, fixed-line, wireless, and high-bandwidth networks. Their businesses follow known patterns through each phase of the economic cycle and thus tend to preserve 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 provide 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 can maintain stable prices during an economic decline. For instance, gold has historically produced a high return amid 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 gold.

How to Invest in Defensive Sector Funds

You can purchase defensive sector mutual funds or ETFs through a brokerage or investment firm. 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 will not be a disproportionate amount of the overall scheme.

Diversify

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, healthcare is a defensive sector, but if you invest all of 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 among funds in the healthcare, consumer staples, utilities, and telecommunications sectors, you can enjoy greater diversification. In turn, you would reduce—but not eliminate—the amount of loss you might experience in your portfolio if one defensive industry were to decline. That is because not all of these industries will go up or down in price under the same types of economic conditions.

Pay Attention to Sub-Sectors

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. However, if a fund invests in this sub-sector and no others, a decline could result in an outsized decline in the value of your holdings. Choosing defensive stock funds with holdings in a variety of sub-sectors within a given sector can make for less severe losses during a downturn.

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.