ETFs are good way to own the utilities sector. Utilities are
prized for their stability, regular cash dividends, and tendency
to reduce portfolio beta. Unfortunately in some instances
individual utilities have not been as stable as their reputation
suggests. ETFs solve this problem by reducing concentration in
individual companies. Diversification helps achieve
When Japans earthquake damaged its nuclear operations,
utilities worldwide sold off in sympathy with Tokyo power
generator TEPCO. Hardest hit were utilities with nuclear assets,
like Entergy (NYSEArca:ETR) and Exelon (NYSEArca:EXC). Although
both of these companies are held in utilities ETFs, the diversity
of the ETF structure minimized losses for investors. The chart
below shows the performance of a utilities ETF, the iShares Dow
Jones U.S. Utilities (NYSEArca:IDU), Entergy and Exelon in the
days following the nuclear disaster in Japan.
EXC is IDUs second largest holding, comprising over 5% of the
fund. ETR is not in IDU's top ten holdings. Though diversity and
protection is inherent in the ETF structure, the goals of most
utility investors (stability and regular dividends) are
particularly well suited to ETFs. Not since California
electricity crisis of 2000-2001 when utilities were forced to buy
power on the spot market has there been so precipitous move in
utilities stock. Then, as now, investors with a portfolio
concentrated in impacted companies suffered.
Utilities belong in every portfolio but investors may want to
underweight or overweight the sector depending on the three most
important factors influencing the price of utilities: politics,
and the market cycle, interest rates. During most of the Bush
era, utilities outperformed every sector other than oil.
Utilities investors benefitted from 1) a regulatory-friendly
administration 2) broad domestic market stagnation outside of
energy 3) declining long bond yields. New regulation hurts
profitability. Strong markets make utilities less profitable on a
relative basis. Declining bond yields make the dividends
utilities pay relatively more attractive.
On regulation: nuclear utilities after Japans earthquake may
face new regulation, but demand for electricity is stable. The
power generated by nuclear plants is difficult to replace. Even
if few new nuclear plants are built domestically (China allegedly
has plans to build over 200 plants) all but a very few existing
plants nuclear plants will probably have their licenses renewed.
Market demand for carbon-free emissions is also intense.
On market direction: Utilities tend to underperform in the
early and middle stages of a bull market. They outperform in the
later stages of a bull market and in a cyclical bear market. The
bull market began March of 2009. The chart below compares IDU
with the Standard and Poors Depositary Receipts (NYSEArca:SPY) on
a three year basis.
Because they are de facto monopolies, utilities are regulated.
They are allowed a profitbut not too much profit. In times of
market expansion, this regulation slows profit growth. In
comparison with the less regulated sectors, utilities
underperform. But as the chart shows, in times of market
contraction, investors tend to be glad to get utilities
On bond yields: Because they compete with U.S. treasury bonds
for yield, utilities ETFs tend to be sensitive to interest rate
changes. During most of the Bush era, utilities ETFs paid yields
lower than the 10-year treasury note. With treasuries currently
near their all-time highs, yields have fallen below 3.5%.
Utilities ETFs yields tend to be around 4%. This means that they
currently yield more than treasuries. While the current
environment of very low treasury yields is a good reason to
prefer utilities ETFs, the potential for inflation or higher
treasury yields in the coming months represents perhaps the
biggest risk to utilities ETFs.
A list of utilities ETFs and their expense ratios follows:
Utilities Select Sector SPDR (NYSEArca:XLU), annual fees:
Vanguard Utilities ETF (NYSEArca:VPU), annual fees: 0.24%
iShares Dow Jones U.S. Utilities Sector Index Fund
(NYSEArca:IDU), annual fees: 0.48%
iShares S&P Global Utilities Index Sector Fund
(NYSEArca:JXI), annual fees:0.48%
Wisdom Tree's Utilities Sector Fund (NYSEArca:DBU), annual
PowerShares Dynamic Utilities Portfolio (NYSEArca:PUI), annual
First Trust AlphaDEX Fund (NYSEArca:FXU), annual fees:
Ultra Utilities ProShares ETF (NYSEArca:UPW), annual
Ultra Short ProShares Utilities ETF (NYSEArca:SDP), annual
has been writing about ETFs since 2003 and is the author of
Sector Trading: A Year in Exchange Traded