Portfolio Construction: XLP vs. IYK for Defensive Exposure

For investors seeking a reliable defensive position, the choice often narrows to two ETFs: the pure-play consumer staples fund XLP and the broader defensive tilt IYK. This creates a classic portfolio construction trade-off between cost and diversification.

XLP is the low-cost specialist. It charges a minimal 0.08% expense ratio and holds a concentrated portfolio of 36 stocks, providing direct exposure to the consumer staples sector. With $14.7 billion in assets under management, it is the dominant player in this space. Its top holdings are anchored by retail giants like Walmart and Costco, offering a focused bet on steady consumer demand.

IYK takes a different approach. It blends consumer staples with other defensive sectors, holding 54 stocks across consumer defensive (85%), healthcare (11%), and basic materials (2%). This fund carries a higher fee, charging 0.38%, nearly five times the cost of XLP. Its thesis is that this broader mix provides a more resilient defensive layer, hedging against sector-specific volatility.

Both funds offer a similar income stream, with dividend yields of 2.75%. Performance over the past year shows IYK's broader approach delivered a slightly stronger 1-year total return of 11.3% compared to XLP's 9.9%. However, the key question for a portfolio manager is whether that incremental return justifies the higher cost and the shift away from pure sector concentration. The core dilemma is clear: XLP offers cheaper, purer defensive exposure; IYK's higher price may be warranted by its diversification, but only if that diversification adds meaningful risk-adjusted return.

Risk-Adjusted Return Analysis

The performance gap between the two funds is clear, but the context of that gap is critical for a portfolio manager. As of early February, IYK delivered a 1-year total return of 11.3%, outperforming XLP's 9.9%. On the surface, that 140 basis point edge suggests IYK's broader diversification paid off. Yet this result must be viewed against the sector-wide underperformance of 2025.

Consumer staples stocks were a defensive laggard last year, widely underperforming the broad-based S&P 500. The primary drivers were a powerful rotation into AI-driven growth stocks and specific sector headwinds, including concerns over GLP-1 weight-loss drugs potentially reducing consumption of certain foods and beverages. In this environment, IYK's slight outperformance likely stemmed from its inclusion of healthcare names, which may have provided a partial hedge against pure staples volatility. For a portfolio seeking to hedge against a broad market rotation, this diversification could be seen as adding a layer of systematic risk mitigation.

However, the trade-off is evident in portfolio construction. XLP's concentrated portfolio of 36 stocks, anchored by retail giants, inherently carries higher idiosyncratic risk. Its performance is more tightly coupled to the fortunes of a smaller group of companies. IYK's broader mix of 54 holdings across consumer defensive, healthcare, and basic materials dilutes this single-stock risk. This is reflected in longer-term risk metrics, where IYK's maximum drawdown over five years was 15.04%, compared to XLP's 16.31%. While the difference is modest, it illustrates the risk-reduction benefit of diversification.

The bottom line for risk-adjusted return is nuanced. IYK's higher fee and broader mandate delivered a marginal performance edge in a tough year, likely through a subtle diversification benefit. For a portfolio manager, the question is whether that edge justifies the cost and the shift away from pure sector exposure. The evidence suggests the diversification provides a slight buffer against sector-specific volatility, but the core defensive thesis of both funds-steady demand for essentials-was tested by powerful market forces in 2025. The risk-adjusted picture favors IYK's approach, but the margin is thin.

Portfolio Construction: Alpha vs. Beta and Correlation

For a portfolio manager, the choice between XLP and IYK is a classic bet on defensive alpha versus diversified defensive beta. XLP offers a cheaper, purer play on the consumer staples sector. Its concentrated portfolio of 36 stocks aims to capture the sector's inherent stability and steady dividend yield, providing a straightforward hedge against broad market volatility. This is defensive beta-exposure to the sector's systematic risk and return.

IYK, by contrast, constructs a more complex defensive position. Its inclusion of healthcare stocks, which make up 11% of the portfolio, is a deliberate hedge. This mix provides a layer of diversification that can help insulate the fund from staples-specific risks, such as shifts in consumer spending patterns or sector-specific concerns like the potential impact of GLP-1 weight-loss drugs. In a portfolio context, this is a tactical move to reduce idiosyncratic risk and potentially improve the risk-adjusted profile of the defensive allocation.

The 2026 outlook suggests a more favorable backdrop for this defensive thesis. After a tough 2025 where the sector underperformed the S&P 500, analysts point to improving fundamentals. The investment environment is expected to benefit from fiscal stimulus and easing sector-specific pressure, which could support demand and valuations. This sets up a potential re-rating for the entire defensive cohort, but the core trade-off remains.

The bottom line is a cost-versus-diversification calculus. XLP delivers the defensive alpha of a pure sector bet at a minimal fee. IYK's higher cost buys a more diversified defensive beta, with the healthcare tilt acting as a sector-specific hedge. For a portfolio seeking to hedge against a rotation into growth, IYK's broader mix may offer a more resilient hedge. Yet for a manager focused on minimizing tracking error and capturing the sector's pure cash flow, XLP's lower cost and concentration present a compelling alternative. The choice hinges on whether the marginal diversification benefit justifies the premium.

Drawdown Characteristics and Volatility

The defensive profile of consumer staples is rooted in the inelastic demand for essentials. Companies in this sector produce everyday goods like packaged foods, toiletries, and household cleaners, whose sales remain relatively stable through economic cycles. This inherent stability is the core of the defensive thesis for both XLP and IYK. Historically, this has translated into lower volatility and more predictable cash flows compared to cyclical sectors.

However, the 2025 experience shows that this profile is not immune to market forces. The sector was a defensive-oriented laggard last year, widely underperforming the S&P 500 as investors rotated into AI-driven growth. This demonstrates that the defensive label does not guarantee outperformance; it simply means the sector tends to hold up better during broad market sell-offs. For a portfolio manager, the key is understanding the sources of potential downside risk.

Two specific catalysts could challenge the sector's defensive stability. First, monitoring consumer spending data is critical. The Schwab Sector Views note pockets of consumer stress, especially among lower-income groups, which could pressure discretionary spending and indirectly affect staples through shifts in mix or volume. Second, the potential impact of GLP-1 weight-loss drugs remains a sector-specific concern that could reduce consumption of certain foods and beverages, introducing a new, persistent headwind.

The most significant risk to the defensive allocation, however, is sector rotation. As the Schwab outlook suggests, Communication Services, Industrials, and Health Care remain Outperform ratings, indicating continued investor preference for growth and AI-adjacent themes. This creates a persistent drag on staples, as seen in the 2025 underperformance. For a portfolio, this means the defensive hedge provided by XLP or IYK is not a static shield. Its effectiveness depends on the broader market's appetite for risk. If the rotation into growth reignites, the defensive allocation could once again lag, forcing a portfolio manager to weigh the cost of holding a lagging asset against the benefit of its stability during a broader downturn.

In practice, this volatility dynamic makes the choice between XLP and IYK a bet on the sustainability of the defensive rotation. XLP's pure-play concentration may amplify sector-specific volatility if a catalyst like a spending slowdown hits. IYK's diversification, particularly its healthcare tilt, may provide a smoother ride by hedging against such idiosyncratic risks. The bottom line is that the defensive profile is a relative, not absolute, characteristic. Its value as a portfolio hedge is contingent on the market environment and the manager's view on the durability of current sector preferences.

Catalysts and Key Watchpoints

For a portfolio manager, the decision between XLP and IYK is not a one-time allocation but an ongoing bet on specific catalysts and risks. The forward view hinges on three critical factors: cost, correlation, and the sustainability of the improving sector backdrop.

First, the expense ratio is a material, compounding factor. IYK's 0.38% fee is nearly five times XLP's 0.08%. Over a multi-year holding period, this cost differential can significantly erode net returns. For a long-term defensive allocation, this is a persistent drag. The slight 1-year performance edge of IYK may not be enough to overcome this fee over a full market cycle, making XLP's lower cost a compelling advantage for cost-conscious investors focused on maximizing after-fee returns.

Second, correlation dynamics are paramount. The defensive thesis assumes these funds move independently of the broader market's risk-on rotation. However, as seen in early 2026, correlation can shift. The data shows a notable rotation: while growth stocks like Communication Services have pulled back, XLP has gained 7.6% year-to-date, while the utilities sector (XLU) has declined. This suggests that within the defensive cohort, there is still a hierarchy of preference. Monitoring the correlation of XLP and IYK with other defensive anchors like utilities (XLU) and gold (IAU) is crucial. If all defensive assets move in lockstep during a market selloff, the diversification benefit within the defensive basket diminishes. A portfolio manager must assess whether the healthcare tilt in IYK provides a true hedge against staples-specific risks or simply adds another defensive beta exposure.

Finally, the sustainability of the 2026 improvement backdrop is the overarching catalyst. The sector's outlook has shifted from a defensive-oriented laggard to a "market perform" rating, supported by expectations of fiscal stimulus and easing sector-specific pressures. Yet this setup is fragile. New risks could emerge, including the pockets of consumer stress noted by Schwab, particularly among lower-income groups, which could pressure discretionary spending and indirectly affect staples. More fundamentally, the persistent concern over GLP-1 weight-loss drugs remains a structural headwind. The key watchpoint is whether the sector's improved fundamentals can withstand these pressures and whether the current rotation into defensive sectors is a durable shift or a temporary pause in the growth rally. If the rotation into AI-driven growth reignites, the defensive allocation's lagging performance could resume, testing the portfolio's patience and the rationale for holding a premium-cost fund like IYK.