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ETF Specialist

Play Defense With This ETF

A low-cost way to access 39 consumer defensive firms found in the S&P 500.

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U.S. consumer defensive stocks have rallied during the past year. Driving the U.S. consumer staples sector's outperformance have been several factors, chief among them interest rates that have gone lower. As many investors have stretched for yield in an era of ultralow interest rates, they have looked for bondlike substitutes in equity sectors like consumer staples and utilities. And with rates falling further, it's likely that some investors looking for income have sought solace in the consumer staples sector. That's not the entire story, however. Also driving the sector's success have been a generally strong U.S. consumer and higher valuations from takeover speculation that has swirled in the space.

Looking ahead, rising interest rates are a risk for the sector, along with continued strength in the dollar (which can be bad for some U.S. staples firms' overseas businesses) and weaker global consumer spending. Potential catalysts for consumer staples firms are innovation and product extensions, prudent acquisitions, and growth in emerging and developing markets.

For investors currently interested in consumer defensive stocks,  Consumer Staples Select Sector SPDR (XLP) remains a strong choice for exposure to the sector. This exchange-traded fund holds a portfolio of mega-cap household names whose products consumers largely stick with regardless of the economic climate. As a result, its holdings generally have stable revenue growth and cash flows.

Food and staples retailers make up 27% of this ETF's assets, followed by beverage producers (20%), household products firms (19%), food producers (17%), and tobacco companies (15%). The fund has been 81% correlated with the S&P 500 during the past 10 years.

During the past decade, this ETF has been meaningfully less volatile than the broader market. It also has displayed less volatility than competing consumer staples ETFs. The fund is less volatile because unlike competing fund  iShares U.S. Consumer Goods (IYK), XLP holds  Wal-Mart (WMT) and several other large, defensive drug and discount retailers. These relatively steadier names have helped to lessen XLP's volatility. In addition, unlike one competing staples ETF, XLP does not hold any automobile-related firms, which generally are far more volatile.

Fundamental View
Apart from rising interest rates--whose timing at this point remains uncertain--two major issues affecting the consumer staples sector right now are foreign currency and global consumer spending. Continued strengthening of the dollar has caused currency headwinds for consumer staples firms with strong overseas sales, weakening these firms' quarterly results. While the U.S. consumer has been strong, Morningstar's equity analysts are cautious in the near to medium term on global consumer spending, particularly in emerging and developing markets. Over the long run, however, our analysts are relatively optimistic about consumer staples firms' prospects in emerging-markets economies.

Food and staples retailers comprise 27% of this ETF. XLP's largest retail holding is Wal-Mart, which has been reinforcing its everyday-low-price strategy through major price cuts. Wal-Mart also is focusing on operating at the lowest cost possible and has invested in its e-commerce capabilities and shifted its capital toward higher-return domestic small stores, instead of lower-return foreign ones. Morningstar's equity analysts assign a Negative Moat Trend Rating to Wal-Mart, which faces greater competition from  Costco (COST) and (AMZN) (which is not held in this ETF), both of which have lower fixed-asset bases and are willing to run their businesses at lower margins. Wal-Mart's small-store expansion may well cut into pure-play grocers held in this ETF, such as  Kroger (KR) and  Whole Foods (WFM). Meanwhile, drug retailers held in this ETF, such as  CVS Health (CVS) and  Walgreens Boots Alliance (WBA), over the longer term stand to benefit from health-care spending growth and an aging population, while their pressures include a pharmaceutical customer base with enormous pricing power and massive nondrug retail competitors. Wide-moat CVS has worked to offset some of these dynamics by becoming a vertically integrated, independent pharmacy benefits manager.

Consumer staples ETFs' dividend yields are in the 2.5%-2.7% range, which is slightly higher than that of the S&P 500.

Although some merger and acquisition activity recently has taken place in the sector (most recently,  Tyson Foods' (TSN) acquisition of Hillshire Brands), investors also should pay close attention to recent pressures on consumer staples companies to split apart, in an effort to drive better focus, share gains, and ultimately earnings growth. Potential breakup targets include  Unilever (UN), Nestle,  Procter & Gamble (PG), and  PepsiCo (PEP).

Portfolio Construction
A market-cap-weighted ETF, XLP invests in the consumer staples stocks of the S&P 500 and employs a cap-weighted structure. Sticking to S&P 500 companies provides an initial screen for quality, as holdings must meet the standards of S&P's selection committee. In fact, some 69% of XLP's assets are invested in wide-moat firms, and 19% are allocated to firms that Morningstar's equity analysts deem as having narrow economic moats (Morningstar's equity analysts define economic moats as durable competitive advantages). Constituents usually have to be leading U.S. companies that meet S&P's profitability criteria. The criteria eliminate large international companies, including Unilever and  Diageo (DEO). XLP holds 39 companies. Consumer staples ETFs track indexes that are labeled either "consumer staples" or "consumer goods." Both types of indexes contain food producers, beverage companies, tobacco firms, and personal-goods firms. However, consumer staples indexes--and by extension, the ETFs that track them--contain food and drug retailers, as well as Wal-Mart, while consumer goods indexes do not. Similarly, consumer goods indexes contain automakers, automotive retailers, and auto components manufacturers, while consumer services indexes do not.

The fund's 0.15% expense ratio is one of the lowest expense ratios of any large and liquid ETF in its category. XLP's estimated holding cost is slightly higher at 0.22%. Estimated holding costs are primarily composed of the expense ratio but also include transaction costs, sampling error, and share-lending revenue.

Investors seeking nondiscretionary exposure to the consumer have plenty of ETF choices. The most similar alternative to XLP is the smaller and less-liquid  Vanguard Consumer Staples ETF (VDC) (0.12% expense ratio). XLP holds just 39 stocks versus VDC's 98 holdings, but the two ETFs show almost perfectly positively correlated performance during the past five years (99%). In terms of assets under management and average daily trading volumes, XLP dwarfs VDC. Thus, large institutional investors demanding deep liquidity in order to move in and out of positions without having a market impact might favor the greater liquidity of XLP or might consider working with an ETF liquidity specialist. However, in our view, VDC still offers sufficient liquidity for individual investors.

XLP and VDC have very similar subsector weightings and in fact have the same top-10 holdings. However, XLP tilts slightly more toward large-cap companies (92% of assets versus 84% of VDC's assets). Probably the biggest difference between the two ETFs is one of concentration--XLP's index assigns heavier weightings to its largest holdings than VDC's index does.

Another consumer defensive ETF is iShares U.S. Consumer Goods IYK (0.43% expense ratio), which offers very similar exposure but excludes the major retailers held by VDC and XLP. Unlike XLP and VDC, IYK also holds auto manufacturers such as  Ford (F) and some apparel companies not found in other consumer staples ETFs, such as  Nike (NKE).

A very inexpensive option is Fidelity MSCI Consumer Staples Index ETF (FSTA), which charges 0.12% and greatly resembles the Vanguard offering. However, FSTA remains small and is less liquid than VDC. It tracks a slightly different index from Vanguard Consumer Staples ETF; FSTA tracks the MSCI USA IMI Consumer Staples, while VDC tracks the MSCI US Investable Market Consumer Staples 25/50 Index. Fidelity customers with a minimum balance of $2,500 can buy FSTA commission-free, although they are subject to a short-term trading fee.

Those interested in gaining exposure to international consumer staples titans can consider  iShares Global Consumer Staples (KXI) (0.47% expense ratio). KXI consists almost entirely of food and beverage producers and large European retailers.


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Robert Goldsborough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.