Consumer Staples

Consumer staples ETFs are lagging despite a weak economy that usually favors the sector. Why? What is ahead for consumer staples ETFs?

After many years of solid outperformance, consumer staples ETFs are underperforming both the broad market and consumer discretionary funds. The two charts below compare the Vanguard Consumer Staples ETF (NYSEArca:VDC) with Vanguard Consumer Discretionary ETF (NYSEArca:VCR) and the benchmark SPDR S&P 500 (NYSEArca:SPY) on a 1-year and on a 5-year basis.

The first chart shows the staples ETF VDC underperforming VCR by 10% over the last 12 months. The second chart shows the longer-term outperformance. The second chart shows the reverse. In boom times investors expect staples ETFs to underperform. In less steady markets, as the current market is mostly perceived to be, staples ETFs are expected to do well.

Investors expect outperformance from consumer staples ETFs in uncertain times because these ETFs hold companies with relatively inelastic demand curves. Holdings focus on manufacturers of food and beverages, drugs, tobacco and household products. Major holdings include Proctor and Gamble, Phillip Morris and Walmart. These items and outlets are deemed essential and non-discretionary. Consumers have a tough time switching or cutting back.

Consumer staples ETFs are often compared with consumer discretionary funds. The discretionary sector is the other side of the consumer coin. Discretionary funds hold companies that sell non-staples, non-necessities-- retailers like Amazon and Home Depot and entertainment providers like DirectTV and Comcast. As the chart shows, the discretionary sector fund VCR has improved.

This may reflect a regression to the mean phenomenon. In valuation terms the two sectors are currently comparable. VDC has a P/E ratio of 15 as opposed to 16 for VCR. The SPY currently has a P/E ratio of 14. This seems to reflect virtually equal expectations from investors for these ETFs. Historically the consumer sector has had higher valuation than the SPY. The staples sector has a lower P/E ratio than discretionary. This is an indication that, relative to the discretionary sector, investors have been unwilling to pay up for earnings in staples. Growth prospects are seen as lower. In fact, for over a decade P/E ratios in staples have been contracting. There is no sign yet that this trend is changing. Consumer discretionary sector earnings are less predictable. P/E ratios in the discretionary sector are more elastic. They are also somewhat less reliable. Prior to the financial crisis it was not unusual to see P/E ratios in the consumer discretionary sector of 40 or higher.

One of the issues for staples ETFs is earnings. The staples sector faces food inflation that has been difficult to pass on to consumers. There are as yet few signs that inflation in this sector is stabilizing, though price increases may be more tolerable. Investors can look for a rebound in the staples ETFs when food costs begin to moderate or inflation can be better tolerated by consumers.

Higher food costs are driven mostly by demand, though speculation also plays a role in commodity pricing. Increased demand from an emerging middle class overseas is one cause of food inflation. This ultimately may prove to be a positive for the food giants held in staples ETFs. According to World Bank data, over 300 million people in China, 100 million in India and 60 million in Brazil are in the emerging middle class category. Although the numbers vary, in poorer societies, families tend to devote a greater percentage of income to staples. Expenditures on food and staples may be 50% or more of total expenditures.

In addition to the plain vanilla consumer staples ETFs like XLP and VDC, several fundamental funds seek to beat the standard indexes. These funds take a strategic approach to staples allocation. They typically allocate more to mid-cap names than VDC. As a result, First Trust Consumer Staples AlphaDEX Fund (NYSEArca:FXG), Powershares Dynamic Consumer Staples Sector Portfolio ETF (NYSEArca:PSL), and Rydex S&P Equal Weight Consumer Staples ETF (NYSEArca:RHS) tend to be more volatile. They have higher expense ratios and usually higher turnover. FXG for example has an expense ratio of 0.70% and an annual turnover of close to about 170%. RHS is an equal weight fund. Its expense ratio is 0.50% and an annual turnover of 25%. PSL comes in at 0.65% with an annual turnover ratio of 67%. These are not necessarily unreasonable expenses ratios. It may be worth paying up for this allocation. All are lower than typical mutual funds in this category

For investors looking to overweight food, PowerShares Dynamic Food & Beverage (NYSEArca:PBJ) puts a special focus on companies like General Mills (NYSE:GIS) and Heinz (NYSE:HNZ), rather than the broad-based staples ETFs mentioned above. Though PBJ has a higher expense ratio, this as an attractive option for investors looking for a strong subsector fund.

Below a list of consumer staples ETFs:

General

• Vanguard Consumer Staples ETF (NYSEArca:VDC)
• Consumer Staples Select Sector SPDR Fund (NYSEArca:XLP), 0.22%

International

• iShares S&P Global Consumer Staples Sector Index Fund (NYSEArca:KXI), 0.48%
• PowerShares Dynamic Consumer Staples Sector Portfolio ETF (NYSEArca:PSL), 0.65%
• SPDR S&P International Consumer Staples Sector ETF (NYSEarc:IPS), 0.50%
• Emerging Markets Consumer ETF (ECON)
• Global X Brazil Consumer ETF (BRAQ)
• Global X China Consumer ETF (CHIQ)

Fundamental

• First Trust Consumer Staples AlphaDEX Fund (NYSEArca:FXG)
• Rydex S&P Equal Weight Consumer Staples ETF (NYSEArca:RHS)
• Powershares Dynamic Consumer Staples Sector Portfolio Fund (NYSEArca:PSL)

Sub-Sector

• PowerShares Dynamic Food & Beverage (NYSEArca: PBJ)