Utility ETFs: Split the Difference

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Utilities ETFs are a good choice for investors looking for yield if they are able to tolerate a little equity exposure. Utilities ETFs hold portfolios of regulated utility companies with guaranteed profit margins. They pay hefty dividends. Currently, utility ETF dividends yield about 2% more than benchmark U.S. treasury bonds.

Utilities and their dividends are historically stable. Utility income and profit is inelastic. It fluctuates within a tight band of demand for water, electricity, and natural gas. The price of utility ETFs is further also anchored by their dividends.

Utility ETFs like other utility funds are not counter cyclical, but they are defensive. Utility ETFs have a beta of around 0.5. This means that although they tend to move with the equity markets, they move up less then benchmark equities when the market goes up and down less when the market goes down.


The chart below compares a key utilities ETF, the Utilities Select Sector SPDR (NYSEArca:XLU) with a fixed income benchmark, the iShares Barclays 7-10 Year U.S. Treasury (NYSEArca:IEF) and an equity benchmark, the Standard and Poor's Depository Receipts (NYSEArca:SPY).

As the chart shows, over the past 12 months the utility ETF XLU has split the difference between fixed income and equity. XLU has outperformed treasury bonds, underperformed equity. Notable is that on the big run-up from May to December of 2009, as the market reacted to being oversold in March 2009, XLU parperformed the SPY. XLU did not participate in this year's rally, the sharp move up in the first few months of 2010. They provided defense against the recent sell-off.

Risks to utility investing include sensitivity to regulatory changes, interest rate risk and systematic market risk. From a regulatory perspective, the biggest challenge to utilities from the Obama administration is uncertainty surrounding greenhouse gas legislation. Change on greenhouse gasses is coming slower than some utilities industry experts feared. Although utilities can do well in a regulated environment, certainly they profited handsomely from the hands-off approach of the Bush years. Some current proposals, such as building a smart grid and cleaner energy incentives for utilities, though they sometimes receive criticism from the industry, may benefit the industry in the longer run by removing uncertainty and encouraging consolidation.

Because they compete with U.S. treasury bonds for yield, utilities ETFs also tend to be sensitive to interest rate changes. This also is less of a factor in the current environment. Interest rates are forecast to remain at low levels and many investors are buying U.S. treasury bonds out of fear or necessity rather than for their yield.

Concerning systematic risk, unlike treasury bonds and gold, utilities are not a safe haven per se. But with their low beta and the company-specific diversification provided by the ETF structure, utilities ETFs can be expected to outperform in both sideways markets and down markets.

In addition to domestically focused ETFs, several ETFs provide exposure to global utilities markets. In the past few years, global utilities ETFs have been more expensive than domestic funds. Their yields were lower compared to domestic utility funds. But with the dollar strengthening recently, internationally focused utilities ETFs have fallen sharply in comparison with their domestic brethren. Although yields on international utilities ETFs are not as regular as domestic funds, it appears that prices have fallen faster than yields. Yields in international utilities funds in some cases now exceed domestic yields. The chart below, which compares XLU with Wisdom Tree's Utilities Sector Fund (NYSEArca:DBU), shows the steep fall in the price of an international utility fund.

As the chart shows, the two funds have diverged widely in the last year. All DBU's top holdings are outside the U.S. 75% are in Europe. DBU can be compared to iShares Global Utilities Sector Index Fund (NYSEArca:JXI), which has more domestic exposure and currently pays lower yields.

The most important utilities sector ETFs and their expense ratios follow.

DOMESTIC

Utilities Select Sector SPDR (NYSEArca:XLU), annual fees: 0.24%

Vanguard Utilities ETF (NYSEArca:VPU), annual fees: 0.25%

iShares Dow Jones U.S. Utilities Sector Index Fund (NYSEArca:IDU), annual fees: 0.48%

INTERNATIONAL

iShares S&P Global Utilities Index Sector Fund (NYSEArca:JXI), annual fees:0.48%

Wisdom Tree's Utilities Sector Fund (NYSEArca:DBU), annual fees:0.58%

STRATEGY

PowerShares Dynamic Utilities Portfolio (NYSEArca:PUI), annual fees:0.60%

First Trust AlphaDEX Fund (NYSEArca:FXU), annual fees: 0.70%

LEVERAGE/SHORT

Ultra Utilities ProShares ETF (NYSEArca:UPW), annual fees:0.95%

Ultra Short ProShares Utilities ETF (NYSEArca:SDP), annual fees:0.95%

Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds .

Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds . Jonathan Bernstein Sector Trading: A Year in Exchange Traded Funds



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs


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