ETF Expert Shines a Light on Utilities

04/07/2014 9:00 am EST

Focus: ETFs

Mark Salzinger

Editor and Publisher, The No-Load Fund Investor

 

Surging US stocks left staid utilities behind in 2013; but with interest rates still low and the sector's yield far higher than that of the S&P 500, utilities are more attractive than they have been in the past couple of years, suggests fund expert Mark Salzinger in his The Investor's ETF Report.

The surging US stock market left staid utilities behind in 2013; while the S&P 500 (SPX) gained more than 32%, SPDR Select Sector Utilities (XLU) gained only about 13%, a decent absolute gain, but a poor relative one.

Rising interest rates contributed to utilities’ struggles in 2013. They increased utilities’ funding costs and made the companies’ dividends less attractive, relative to interest payments from bonds.

Many utilities borrow money to finance capital projects, which regulators allow because it gives utilities access to new funds without having to raise customers’ rates.

While higher borrowing costs restrict utilities’ access to capital, rates are not as high in early 2014 as they have been historically, or even as high now as they were just six months ago.

The S&P 500 recently yielded just 1.9%, while XLU yielded more than twice that at 4.1%. XLU also has been consistently 15% to 20% less volatile than the S&P 500 over the past five years.

Another part of utilities’ struggles has been the weakness of merchant power generation, an unregulated business in which utilities with excess generation capacity sell power to other utilities.

Natural gas has been so inexpensive over the past few years that merchant power operations, fired by coal or nuclear energy, simply aren’t profitable. Regulated utility operations have benefited from access to an inexpensive fuel at the expense of unregulated operations.

However, a steadily strengthening economy and falling unemployment rate augur well for greater demand over the longer-term. There are numerous utility ETFs, all of which own the same handful of three to four dozen US utilities in roughly the same proportions. We prefer XLU.

The SPDR Select Sector Utilities is, by far, the largest utility sector ETF, with more than $5 billion in assets, and it has the narrowest bid ask spread—recently just a single penny. It invests in the largest US utilities, weighted by market capitalization.

The portfolio includes a mix of regulated and non-regulated utilities, as well as a handful of gas utilities. XLU has gained 3.0% so far in 2014 (through January 31), versus the S&P 500’s 3.5% loss. XLU has a 0.18% expense ratio.

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