After years of benefiting from a nearly uninterrupted bull market, investors finally had to deal with a market correction during the third quarter. Yet even as concerns loomed over much of the market, certain industry sectors fared quite a bit better than others.
By using various sector-specific exchange-traded funds, you can tailor your market exposure to whichever industries you think have the best likelihood of producing profits. Even in market downturns, some sectors tend to perform better than others, and that phenomenon showed itself during the summer months. Let's take a look at the three best-performing sector ETFs to get some hints on where investors might want to look for further strength in uncertain conditions.
Utilities ramp up the power
The best performer among the SPDR Select ETF group was the Utilities Select Sector SPDR ETF (NYSEMKT:XLU), which rose more than 5% during the quarter. In fact, the Utilities ETF was the only one among the sector SPDR ETFs to post gains for the third quarter.
The reason for utilities' outperformance was largely that long-feared increases in interest rates failed to occur amid concerns about the ability of the U.S. economy to keep growing at its current pace. Utilities tend to have predictable income streams, but limited growth potential, and that makes their stocks trade largely in line with the bond market. With delays on higher rates, utility stocks looked more attractive, and that helped the ETF cut its year-to-date losses nearly in half during the third quarter.
Feeding off the consumer
The other two best-performing sector ETFs in the SPDR family both came from the consumer realm. The Consumer Staples Select Sector SPDR ETF (NYSEMKT:XLP) fell just 0.2% during the quarter, while the Consumer Discretionary Select Sector SPDR ETF (NYSEMKT:XLY) posted a slightly larger 2.6% decline.
Consumer staples often serve as a smart investment during down markets, as investors see the businesses that underlie stocks in the sector as being more resilient to economic downturns. In particular, with demand for staple goods remaining largely intact even when money is tight, these companies don't see as much variance in their financial results. That, in turn, typically leads to smaller losses for their shares. In addition, many companies in the consumer staples industry pay lucrative dividends, and that can also serve to act as a buffer against market turbulence, especially when healthy sources of investment income are at a premium.
It makes sense that discretionary companies would typically fare not as well during poor markets, as their exposure to changing economic conditions is typically greater. Yet don't let the term "discretionary" fool you, as many of the companies in this category sell goods that people have come to take as necessities.
Moreover, with gasoline prices remaining extremely cheap, consumers have more disposable cash available than usual with which to consider bigger-ticket purchases. Automakers, for instance, are on track to see their best sales figures in years. If the favorable conditions for ordinary Americans continue, then discretionary stocks could continue to outperform rivals in other industries.
What's ahead for these sectors?
Of these three groups, the utility sector is arguably the most at risk of a reversal in the near future. Although interest-rate increases aren't coming as soon as most had anticipated, they are inevitable. When they happen, stocks will typically follow their historical pattern of declining.
By contrast, consumer stocks could continue to hang in, even if the economy starts to deteriorate. Discretionary stocks would likely be the first to show signs of stress, so risk-averse investors might prefer to stick with staples if you believe further market weakness is imminent.
Of course, with any investment decision, there's a trade-off. The same sector ETFs that do well during down markets tend to lag on the upside, so the real question is whether you think stocks have further to correct, or will bounce back from here. Whichever you decide, though, using an ETF to get sector-specific exposure can be the most efficient way to tailor your portfolio the way you want it to look.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.