September has a reputation for being the cruellest month of the year for stocks. October can also make investors jittery because two of the biggest stock market crashes – in 1929 and 1987 – occurred that month.
It’s not clear whether a pullback or a correction – a greater than10-per-cent decline – could be in the offing, but risks appear to be rising. North American stock markets have hit record highs recently, while the COVID-19 Delta variant surge and China’s regulatory crackdown are creating uncertainty.
Although the U.S. Federal Reserve Board indicated in late August that rising interest rates are not yet on the horizon, it expects to begin reducing its massive stimulus by decreasing or “tapering” its bond purchases gradually by year-end.
Investors can move into cash or bonds to preserve capital, but it’s difficult to time the market. Defensive exchange-traded funds (ETFs) are one way to maintain equity exposure, and potentially feel less pain in a market downturn.
We asked three ETF experts for their top defensive picks.
Daniel Straus, director of ETF research and strategy at National Bank Financial Inc.
The pick: BMO Equal Weight U.S. Health Care ETF ZHU-T
Management expense ratio (MER): 0.39 per cent
This health-care sector ETF is a defensive play because it invests in U.S. companies whose products or services are necessary, regardless of economic conditions, Mr. Straus says. Launched in 2019, top holdings include Moderna Inc. MRNA-Q, Danaher Corp. DHR-N and Intuitive Surgical Inc. ISRG-Q. The ETF’s equally weighted stocks mean avoiding bigger stakes in high-valuation companies, but there is still downside risk because the ETF holds equities, he adds. While both the ETF and the S&P 500 Index both dropped by more than 30 per cent during the COVID-19-induced market crash in early 2020, this ETF should outperform the lofty-valued technology sector that has been propelling the market, he says. Because this low-fee ETF is unhedged, it’s also more defensive because the U.S. dollar tends to appreciate relative to other currencies in sharp market declines as a “flight to safety,” he says.
The pick: Simplify U.S. Equity Plus Downside Convexity ETF SPD-A
MER: 0.28 per cent
This U.S. equity ETF aims to protect capital during sharp market downturns through a put-options strategy, Mr. Straus says. “You’re trusting an active manager to do a risk-management overlay.” This one-year-old ETF hasn’t proven itself, but “what it does is fairly transparent and understandable,” he says The ETF is 98 per cent invested in the S&P 500 Index via iShares Core S&P 500 ETF IVV-A for upside potential, while the value of the put options should appreciate to offset steep market drops, he adds. The ETF is not designed to protect against minor pullbacks, but rather “significant declines,” he stresses. In a rising market over several years, the fund will underperform the benchmark index slightly due to the option premiums, which is like paying house insurance, he says. The ETF’s lower MER currently stems from an annual fee waiver.
David Kletz, vice-president and portfolio manager, Forstrong Global Asset Management Inc.
The pick: Fidelity International High Quality Index ETF FCIQ-T
MER: 0.50 per cent
This ETF can be a defensive play because it’s tilted toward high-quality companies and provides diversification beyond North America, Mr. Kletz says. Canadian investor portfolios are often focused on domestic and U.S. equities, he notes. Launched in 2019, the ETF’s index tracks companies with solid balance sheets and profitable business models to weather tough market conditions, he says. Top holdings include Hellofresh SE HELFY, Roche Holding AG RHHBY, and Sony Group Corp. SONY-N. Given that this is an equity ETF, shares of even the most resilient companies can get hurt during a market sell-off, he says. Still, the fund had a less severe drawdown than market-cap weighted international and North American stock indexes during the COVID-19 induced market crash in early 2020, he notes. The fund’s fee is competitive with its Canadian-listed factor ETF peers.
The pick: Franklin FTSE Japan ETF FLJA-NE
MER: 0.09 per cent
This low-fee, Japanese equity ETF seems like an unlikely defensive play given the implicit leverage to global growth and trade, but it does have attributes limiting downside risk, Mr. Kletz says. The Japanese market, which has benefited from governance reforms, trades at half of the book value of global indexes, he notes. Because the yen is often a safe haven in a global market sell-off, currency gains should offset some losses, he adds. The profile of Japanese equities as an asset class has also changed because of measures to shore up the banking system and the yen’s growing role as a global funding currency, he notes. This Asian market also had “shallower losses than global equities during the 2007-08 global financial crisis and the COVID-19 crash in early 2020.” A risk is the ETF’s exposure to auto makers, which are suffering from a semi-conductor chip shortage.
Pavan Khaira, associate, investment products and platforms, iA Private Wealth
The pick: BMO Low Volatility Canadian Equity ETF ZLB-T
MER: 0.39 per cent
This ETF is a more defensive investment because it offers exposure to Canadian stocks with lower volatility than the broad market, Ms. Khaira says. It holds 46 securities, with about 23 per cent in financials, 15 per cent in utilities, and 15 per cent in consumer staples. The 10 top holdings include Hydro One Ltd. H-T, Franco-Nevada Corp. FNV-T, Metro Inc. MRU-T, Waste Connections Inc. WCN-T, and Thomson Reuters Corp. TRI-T. During the COVID-19 induced market crash in early 2020, the ETF shed 34 per cent from peak to trough versus a 37-per-cent loss for the S&P/TSX Composite Index. A low-volatility ETF is designed to limit the downside, but it doesn’t mean that investors are immune to a serious market sell-off, she says. A risk is that the ETF “may not capture all the upside in a strong bull market.” The ETF’s fee, she adds, is in line with its low-volatility peers.
The pick: Consumer Staples Select Sector SPDR ETF XLP-A
MER: 0.12 per cent
This ETF’s defensive nature stems from investing in stocks of U.S. companies that sell essential products to consumers, Ms. Khaira says. The fund holds 32 companies involved in everything from food and drugs to tobacco as well as household and personal products. It’s invested about 25 per cent in the beverage sector and 24 per cent in sellers of household products. Top holdings include Procter & Gamble Co. PG-N, which makes up 16 per cent of the ETF, Coca-Cola Co. KO-N, and Walmart Inc. WMT-N. During the COVID-19-induced market crash in early 2020, this ETF suffered a 25-per-cent loss versus a 34-per-cent decline for the S&P 500 Index. Consumer staples stocks can fall less than the broader market during a sharp downturn, but can lag in a strong market rally, she notes. The ETF’s fee is on the lower end of the average consumer staples ETF.