Several years since the global financial crisis reached its nadir in early 2009, a robust economic recovery has been largely elusive. Many countries within the developed world have “double-dipped” back into recession, and others threaten to follow. In Europe, even the resilient German economy is managing to eke out only small doses of growth, most recently registering a quarter-over-quarter advance of 0.3% through the end of June. Meanwhile in the US, voters will head to the polls in a general election this autumn with an anaemic domestic economy at the top of their minds.
If you want to protect yourself from dark economic clouds on the horizon, your first moves may be through your broad asset allocation, for example by shifting towards cash and bonds, or hard assets like gold or real estate. But even within the equity sleeve of your portfolio there may be ways to create a defensive tilt.
Here are five strategies to invest defensively, and we have provided an exchange-traded fund (ETF) example that could be used to implement each of the strategies. In every case, the strategy or fund will have distinct risks of its own, and you wouldn’t want to pursue one in isolation, but rather as part of a diversified portfolio. And while some of these did actually provide some valuable cover during the global financial crisis, employing tactics that worked well in the last war is no guarantee of victory in a yet-to-be-fought battle.
1. Stick to the Staples
The consumer staples sector of the economy includes companies that have traditionally been less sensitive to economic cycles, such as those involved in the manufacture or sale of household products, food and beverages, or tobacco. These are often considered “recession-proof” businesses since the demand for them tends to stay strong even during tough times.
Investors looking to add exposure here can do so through SPDR MSCI Europe Consumer Staples ETF (XTS), which has 100% of its assets allocated to the sector. Over the last five years this ETF has been less volatile than the broader MSCI Europe Index, and has shown only a 73% correlation to the index. From late 2007 to early 2009, it suffered a drawdown of 35.85%, far smaller than the broader index’s fall of 53.62%. Please note that these performance numbers are strictly meant for high-level comparisons. They are not equivalent return streams since the index is not a directly investable product and has not had fees levied from it.
A note of caution is warranted, as the ETF has a 21% concentration within a single name, 
Nestle SA (NESN). This leaves unit holders highly exposed to any idiosyncratic risk associated with that company.
To learn more about Nestle, watch this video where Argonaut fund manager Barry Norris explains why he’s invested in the company.
2. Cut Your Beta Down to Size
The beta of an investment describes how volatile it is relative to its benchmark, so those looking to play defence will want to find a fund with a low beta.
Screening by that metric, one that fits the bill is the Lyxor ETF DAXplus Protective Put (LYMT), with a three-year beta of just 0.54. This ETF provides exposure to an index that is long the DAX and also buys put options that will go in the money if the index falls by 5%. In theory that limits the downside for investors, while still giving them the upside of the DAX, less the cost of buying the puts. In a bear market, a fund like this would be expected to outperform. Indeed, this ETF suffered a financial crisis drawdown of just 31.84%, versus 52.35% for the DAX Index (which, again, does not have fees netted out).
3. Seek a Margin of Safety
Value investors always look to buy an investment for less than what they reckon its assets are worth, thereby giving them a ‘margin of safety’ in case things go wrong. On that theory, we should find a degree of shelter in iShares EURO STOXX Telecomm (EXX2), which currently is 98.4% within the ‘value’ realm of the Morningstar Style Box.
To be sure, value investing generally didn’t provide the protection many had hoped for during the financial crisis, in part because many bank stocks looked like good value even before they went into free-fall. This fund fared well though, falling just 34.11%; far less than the broader European markets.
The same caution about concentration risk applies here. Telefonica SA (TEF) is a 32.6% position, and in total the top five names account for 90% of the portfolio.
4. Stand on the Shoulders of Giants
A fortress mentality for wary investors may lead them to seek out exposure to extremely large, multinational corporations. Investors could find such exposure in the Lyxor ETF DJ Global Titans 50 (MGT), which is entirely allocated to companies with ‘giant’ market capitalisations according to Morningstar style classifications.
This ETF has had correlation to the MSCI World Index of just 74% over the last five years, and has had lower volatility. It also provided some cover during the financial crisis, falling less than 45%. By comparison, the MSCI World Index fell by more than 50%.
To learn more about whether it’s best to invest in large-cap companies using an active or passive fund, watch this video: “Active, Passive, or Both?”
5. Go Abroad
Faced with the prospect of recessions in the developed world, it may make sense for investors to seek out the emerging markets. Luckily, there are plenty of ETFs to choose from for this type of exposure. An example fitting the bill is the db x-trackers MSCI EM LATAM TRN Index (XMLA), which concentrates on Latin America.
This isn't what most would consider a defensive play. Emerging markets have historically been an extremely volatile exposure, and in fact suffered badly during the financial crisis. For this strategy to protect you from recessionary forces you are betting on a decoupling of the world's economies, where the fast-growing emerging countries can power forward even as their developed peers stumble. There is no assurance that this will happen: many of the most exciting growth stories are reliant on robust world trade and lots of demand from developed country consumers. Indeed, Brazil has seen its growth slow markedly, and in July the HSBC Brazil PMI, which measures conditions in the manufacturing sector of the economy, stood at just 48.7, the fourth consecutive month with a reading below 50, which indicates contraction. But if growth disappears in Europe and North America, investors may feel they have little choice but to seek it out elsewhere.
Coming Up: Morningstar ETF Invest Conference Europe 2012
Thought Leadership from the Leaders in the ETF Space
Morningstar’s Inaugural ETF Invest Conference Europe will feature some of the sharpest minds in ETF management and top pundits to help sort out the complexities, alternative theories, and investing strategies using ETFs. The event features keynote presentations, and general discussions, on key areas of strategic and tactical investing solutions. The conference will also give you the opportunity to develop and expand your professional network by conversing with fund managers, analysts, providers, and other financial industry experts.
For full details visit the conference web site here.
