Play Defense With This ETF

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,

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

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

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,

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

Fees 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.

Alternatives

Investors seeking nondiscretionary exposure to the consumer have plenty of ETF choices. The most similar alternative to XLP is the smaller and less-liquid

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

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

Disclosure: Morningstar, Inc.'s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.