Playing Defense Isn’t Cheap

October 24th at 8:00am by Tom Lydon

The SPDR S&P 500 (NYSEArca: SPY) has advanced 57.3% over the past three years, but bets on select defensive sector ETFs have paid off even more handsomely.

For example, the Consumer Staples Select Sector SPDR (NYSEArca: XLP) has outperformed SPY by 200 basis over the past 36 months. The Health Care Select Sector SPDR (NYSEArca: XLV) has surged a stunning 79% over the same time. [Health Care ETFs Topping S&P 500 in 2013]

XLV and other health care ETFs have kept the good times going in 2013 as XLV, the largest health care ETF by assets, is up 29.5%. Other defensive ETFs have offered middling performances, particularly as interest rates have jumped. Year-to-date, the Utilities Select Sector SPDR (NYSEArca: XLU) is the worst-performing SPDR while XLP, which is up 22.5%, ranks in the middle of the pack. [Dividend ETFs Under Pressure as Rates Rise]

The recent struggles of low beta, defensive sectors like staples, telecom and utilities says investors might be leaving too much on the table and paying too far up to play defense.

“It’s important not to overpay while seeking safety. Insurance is a wonderful thing, but if the cost of the premium is too high, you may be better off accepting the risk,” said iShares Global Chief Investment Strategist Russ Koesterich on the BlackRock blog. “Today, some of the defensive sectors, such as utilities and consumer staples, are expensive, meaning you may be paying a very large premium to get only short-term risk mitigation.”

Indeed, defensive sectors are pricey. However, the cautionary tale is not just that these sectors are expensive relative to the broader market. Staples, as one example, often trade at elevated premiums to the broader market. The potential cause for concern is that these sectors are now trading at valuations that are elevated relative to their own historical norms. [Some Dividend ETFs Starting to Look Pricey]

“In my opinion, this may not be worth it. In a similar way, investors often overpay for a hedge. This is particularly risky at a time when unconventional monetary policy is still distorting pricing in many asset classes,” noted Koesterich.

One way of looking at the dilemma facing investors shopping for staples or telecom ETFs is that, yes, they will get dividends, but they could be cheating themselves out of higher returns and paying up for the “privilege.”

“In short, defensive companies and sectors play a vital role in a portfolio. That said, defensive companies are not a free lunch,” said Koesterich.

Utilities Select Sector SPDR

ETF Trends editorial team contributed to this post.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.