Defense sector funds are mutual funds or exchange-traded funds (ETFs) that invest in companies in recession-resistant industries. These industries are called “defensive sectors” because they tend to remain stable regardless of the health of the market.
Definition and Examples
Defense sector funds refer to mutual funds or ETFs that primarily (or exclusively) invest in stocks of companies that tend to remain stable throughout all phases of the economic cycle.
Unlike cyclical sectors, non-cyclical sectors are highly dependent on the economic cycle. (Think about financial services, luxury goods, and other items that people won’t buy in large quantities when money is tight.) Unlike cyclical sectors, non-cyclical sectors like healthcare tend to achieve stable profits throughout all phases of the economic cycle. These companies produce goods or provide services that consumers buy regardless of market or economic conditions. Essentials like food, healthcare, and utilities are some types of industries that defensive sector funds may invest in.
“Defensive stocks” can be found in many industries if the company has strong earnings, innovation, pricing power, and a track record of weathering downturns.
How Do Defense Sector Funds Work?
When investors suspect that the economy is likely to decline, many of them start to bolster their portfolios with defense sector funds. This allows them to perform better than the overall market during a market correction or bear market.
A market correction occurs when the market declines between 10% and 20%. A bear market is characterized by a decline of 20% or more and may be accompanied by a recession. When investing in defense sector funds, your main goal is to defend against significant declines in stock prices that may occur during these events.
During tough times, consumers cut back on spending for luxury items such as entertainment, travel, and high-end clothing. Instead, they tend to buy only necessities like food, healthcare services, and basic utilities. If you purchase defensive stock funds that invest in industries like these, your accounts should theoretically decline less than others. This is because the assets that make up your fund are stocks that have remained historically stable in price during market downturns.
Note: Even though defensive sectors tend to remain stable in price throughout the economic cycle, the trade-off is that they provide less dramatic growth during market upswings compared to high-risk cyclical industries.
Types of Defense Sector Funds
Defense sector funds invest in many industries that have historically maintained their value.
Consumer Staples
Consumer staples, also known as “non-cyclical consumer stocks,” tend to maintain price stability in a down market more than cyclical stocks. During an economic downturn, consumers still need essentials like grains and milk, and they may even increase their use of “sin” products like cigarettes and alcohol. Based on this, some investors buy defense sector funds like the Vanguard Consumer Staples ETF (VDC) when they believe a recession is imminent.
Healthcare
This broad defensive sector includes hospitals, other healthcare facilities, insurance companies, pharmaceutical manufacturers, medical device companies, and biotech firms. Healthcare is considered a defensive sector because these companies provide products or services that consumers need to purchase during tough times. After all, health is a primary concern, and people still visit doctors and refill prescriptions even when they can’t afford other goods.
Note: The Vanguard Health Care (VGHCX) mutual fund is an example of a defense sector fund.
Communication Services
This sector includes companies that provide communication services through cellular networks, fiber optics, landlines, wireless, and high-capacity broadband networks. Their businesses follow recognizable patterns in each phase of the economic cycle and thus maintain value when the economy shifts into recession. The Fidelity Select Communication Services Portfolio (FBMPX) is one mutual fund that gives investors the opportunity to invest in this sector.
Utilities
Utilities rely
People rely on gas, electricity, water, and other utilities in their daily lives. Publicly traded stocks include companies that provide or deliver these services. They are considered defensive because consumers still need them during an economic downturn. This reality makes the prices of defensive utility sector stocks less sensitive to market fluctuations. The Vanguard Utilities ETF (VPU) is an example of this type of defensive sector fund.
Some Commodities
Commodities include raw materials such as crude oil, coal, corn, tea, rice, gold, and silver. Not all of these commodities are defensive by default, but some can maintain stable prices during economic downturns. For example, gold is considered a high-yield investment amid economic volatility because many investors see it as a safer alternative to stocks. The Fidelity Select Gold Portfolio (FSAGX) is an example of a mutual fund that targets gold.
Note: During the Great Recession, the value of gold rose significantly. The Producer Price Index for gold increased by 101.1% from 2008 to 2012.
How to Invest in Defensive Sector Funds
You can purchase defensive sector mutual funds or ETFs through a broker or investment company. Before adding these funds to your portfolio, determine your asset allocation, or how your money will be distributed among different asset classes such as stocks and bonds. Then, set up the portion of your portfolio that each asset class should represent so that the stocks you choose are not an excessive percentage of the overall system.
Diversification
When choosing mutual funds or ETFs for your portfolio, try to be diverse in your selection of stocks from different sectors and sub-sectors. For instance, healthcare is a defensive sector, but if you invest all your money in it, the value of your portfolio will rise and fall with price fluctuations in that sector alone; there won’t be another sector to act as a hedge against losses in that sector.
Conversely, if you spread your money across healthcare, consumer staples, utilities, and telecommunications, you can enjoy greater diversification. In turn, you will reduce the amount of loss you may experience in your portfolio if one defensive industry declines. This is because not all of these industries will rise or fall in price under the same types of economic conditions.
Pay Attention to Sub-Sectors
Avoid funds that are overweight in one sub-sector. For example, biotechnology is an attractive sub-sector in healthcare due to its volatility; it is a field with continuous innovation. However, if a fund invests solely in this sub-sector and no others, a downturn could lead to a significant decline in the value of your accounts. Choosing defensive equity funds that contain a diverse range of sub-sectors within a particular sector can make losses less severe during a downturn.
Defensive equity funds can reduce risks and losses in the value of your portfolio during economic downturns, but these funds may also lose value during a market correction or bear market. For this reason, defensive sector funds are most effective when used as part of a diversified portfolio of mutual funds.
Source: https://www.thebalancemoney.com/what-are-defensive-sectors-2466812
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