A Defensive Consumer Staples ETF for an Uncertain Economic Environment

Morningstar's Take
 Consumer Staples Select Sector SPDR (XLP) is the lowest-priced and most liquid exchange-traded fund for broad exposure to a basket of defensive, mega-cap consumer discretionary names. As investors become increasingly concerned about potentially chilly economic winds ahead that could affect more discretionary consumer spending, they might want to consider this ETF, which holds the 41 consumer staples firms that are contained in the S&P 500 Index.

Investors seeking explosive growth are better suited looking elsewhere, as this ETF is chock-full of mature businesses offering relatively stable returns and a clear tilt toward large-cap names. While investors shouldn't expect much higher than mid-single-digit top-line growth from these mature firms, XLP does offer a decent dividend yield.

This is a high-quality, market-capitalization-weighted portfolio, with some 62% of assets invested in wide-moat firms. Another 31% of assets are invested in companies that are deemed to have narrow economic moats. (Morningstar's equity analysts define economic moats as durable competitive advantages.)

XLP probably makes best sense for investors seeking a defensive portfolio tilt.  Not surprisingly, consumer goods companies--such as  Procter & Gamble (PG),  Philip Morris International (PM), and  Coca-Cola (KO)--dominate the portfolio. XLP also holds a slew of nondiscretionary retailers included here, such as  Wal-Mart (WMT) and Kroger (KR). Asset allocators also might consider that the fund has been 85% correlated with the S&P 500 over the past five years.

Fundamental View
The cap-weighted structure of this ETF translates into relatively concentrated exposure to a few noncyclical consumer staples behemoths. For instance, the fund's top three holdings alone account for more than 35% of total assets, and its top 10 holdings comprise more than 69% of assets. Also worth noting is that about 78% of assets are allocated to consumer goods firms, with the remaining 21%-plus invested in nondiscretionary retailers.

XLP is a defensive holding because consumers buy toilet paper, razors, bandages, and baby food regardless of the economic climate. The fortunes of defensive consumer companies such as  Kraft (KFT) and  Colgate-Palmolive (CL) generally depend less on roaring economies than do other more discretionary consumer sectors--such as travel and leisure, for instance. The news has been decent on the demand side for many consumer companies, with continued solid consumer spending.  Reports show that consumers are continuing to spend, despite concerns about future inflation, higher fuel prices, and still-high unemployment. However, no one disputes that consumer spending could change--and more consumer discretionary-oriented names could get hammered--in a hurry, particularly if consumers close their pocketbooks owing to generally weak consumer sentiment, largely flat incomes and still-high unemployment (including minimal job growth at best).  A fund like XLP, on the other hand, should expect relatively stable demand regardless of the economic climate. 

Morningstar's equity analysts project only low- to mid-single-digit top-line growth for these mature firms over the next five years. So, while these firms may offer something of a safety net during difficult economic periods, investors shouldn't pile in with the expectation for exceptional growth during a cyclical upturn.

One potential headwind for companies in this fund is commodity prices. Many of XLP's companies are voracious consumers of commodities. Thus, we think investors should be cognizant of volatility in raw material costs as they consider whether to invest.  However, regardless of where commodity prices go, investors should remember that we anticipate these mature firms to post long-term GDP-type top-line growth. Therefore, at the end of the day, investors with strong convictions related either to currency markets or commodity prices should consider their stances (and the impact on these businesses) before diving in.

Fees
The fund's 0.18% expense ratio is low even by ETF standards.  It also is the lowest expense ratio of any ETF in its space.

Alternatives
Investors seeking nondiscretionary exposure to the consumer have plenty of choices in the ETF world. In our view, the most similar alternative to XLP is the smaller and less liquid  Vanguard Consumer Staples (VDC) (0.19% expense ratio).  Even though XLP owns only 41 stocks versus the 108 companies that VDC holds, the two funds show performance that has been almost perfectly positively correlated over the past five years (99%). In terms of assets under management and average daily trading volume, XLP dwarfs VDC. Thus, large institutional investors who demand 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 considering working with an ETF liquidity specialist. However, in our view, VDC still offers sufficient liquidity for individual investors.

 

 

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