Sector ETFs that could outperform during a recession

Investing during a recession

A recession is generally defined as a general decline in economic activity. Indicators include a shrink in gross domestic product (GDP) for two consecutive calendar quarters, higher unemployment, and lower business earnings. Currently, real GDP decreased at an annual rate of 1.6% in Q1 2022. This less-than-positive sign has traders eagerly watching the next anticipated release from the Bureau of Economic Analysis (BEA). 

Rate hikes can induce recessions as they curb consumer spending and make the cost of capital higher for businesses trying to pursue growth. The latter can translate into poorer revenues, margins, and earnings for companies, which tends to negatively impact their share prices. For growth stocks, a higher discount rate is applied to their valuations and future cash flows, which can severely lower their share price. This is why the technology sector, in particular, has been hard-hit lately. 

However, not all stock market sectors are negatively impacted. More durable, defensive ones like utilities, healthcare, and consumer staples tend to weather recessions better. These sectors see a lesser fall-off in consumer spending thanks to the more essential nature of their products and services. Many also operate in heavily regulated, oligopolistic markets and have wider economic moats thanks to this.

Finally, many of these stocks in these sectors pay strong dividends and have a history of maintaining payments even during economic downturns, which can help offset losses during bear or sideways trading markets. Finally, these sectors tend to have a lower beta, which is a measure of sensitivity and volatility relative to the broader market (typically the S&P 500 Index). 

Investors looking to tilt their portfolios towards these sectors can use the ETF Central screener to find a list of ETFs tracking them. I've provided a list of potential options below and a breakdown of their composition, fees, and strategy.

U.S. Healthcare ETFs

Health Sector Select Sector SPDR Fund (XLV)

• Strategy: Passively managed indexing
• Composition: 64 large-cap U.S. equities 
• Expense ratio: 0.10%
• Distribution Yield: 1.49%

Vanguard Health Care ETF (VHT)

• Strategy: Passively managed indexing 
• Composition: 465 large-cap U.S. equities
• Expense ratio: 0.10%
• Distribution Yield: 1.35% 

U.S. Utilities ETFs

Utilities Sector Select Sector SPDR Fund (XLU)

• Strategy: Passively managed indexing 
• Composition: 29 large-cap U.S. equities 
• Expense ratio: 0.10%
• Distribution Yield: 2.92%

iShares U.S. Utilities Index ETF (IDU)

• Strategy: Passively managed indexing
• Composition: 44 large-cap U.S. equities
• Expense ratio: 0.41%
• Distribution Yield: 2.28%

U.S. Consumer Staples ETFs

Consumer Staples Sector Select Sector SPDR Fund (XLP)

• Strategy: Passively managed indexing
• Composition: 33 large-cap U.S. equities 
• Expense ratio: 0.10%
• Distribution Yield: 2.48%

Invesco S&P 500 Equal Weight Consumer Staples ETF (RHS)

• Strategy: Passively managed indexing
• Composition: 34 large-cap U.S. equities
• Expense ratio: 0.40%
• Distribution Yield: 2.41%

Sector tilts – the final word

Investors should understand that a sector tilt is inherently an active management strategy, regardless of whether they implement it via stock-picking or index ETFs. 

By tilting a portfolio toward a particular sector(s) beyond their market-cap weight, investors are making an active bet on that sector outperforming in the future. This depends on an investor’s ability to accurately forecast macro-economic events, which is difficult even for professional fund managers. Over long periods, this approach can underperform a passive buy-and-hold strategy using broad-market index funds. 

Investors who do decide on a sector tilt must ensure they do sufficient research, have a well-thought-out investment thesis, and stick to their strategy even if it underperforms initially.