At the start of the year, the equities market saw one of its strongest quarterly gains. But the initial market euphoria quickly dissipated as the euro zone crisis reared its ugly head, sending investors into "risk off" mode. While most of the market's attention has been focused on safe-haven Treasurys, utilities sector stocks and exchange-traded funds have been quietly strengthening in the background.
Utilities are your go-to defensive, non-cyclical sector play, with attractive yields and stable growth potential. Even during times of economic distress, people still require basic utilities to slog through the day-to keep the thermostat just right during the summer heat and winter freeze, for example. This recession-resistant investment offers just the right amount of safety and dividends that any income hunter would be looking for. Still, these are equity plays, and potential investors will have to stick to their convictions that the electricity infrastructure will continue to expand as electricity demand rises over the long term.
Investors may take the time to sift through individual company stock picks to compile their own utilities portfolio. However, utilities ETFs have already done the grunt work for you, providing a broad and diversified portfolio of sector picks. Most utility ETF holdings include both regulated utilities, basically government-sponsored monopolies known for their stable business models and predictable dividends, and merchant power generators, which profit on changes in commodity prices.
The utilities industry, especially unregulated and merchant power generators, are mainly influenced by natural gas prices, and natural gas plants typically set the industry standard prices. When these prices are too high, users turn to coal, hydro and nuclear power plants as cheaper alternatives. But natural gas prices are currently sitting at historic lows, so natural gas plants are still in the driver's seat.
This sector is also offering attractive income. Utilities stocks and ETFs currently provide dividend yields of about 4%, while the S&P 500 is only generating a 2% yield and the 10-year Treasury note yields have recently dipped below 1.5%. It should be noted that broad-based indices, like the S&P 500, typically allocate 2% to 4% of their total allocations to the utilities sector, and potential investors should keep this in mind when constructing a broad equities portfolio.
Utility ETF Options
Investors have a range of options to choose from. The largest market-cap-weighted U.S. utility stock ETFs include the Utilities Select Sector SPDR (XLU), which has an expense ratio of 0.18% and a 12-month yield of 3.87%, the Vanguard Utilities Sector ETF (VPU), which has an expense ratio of 0.19% and a 12-month yield of 3.6%, and the iShares Dow Jones U.S. Utilities Index Fund ETF (IDU), which has an expense ratio of 0.47% and a 12-month yield of 3.37%.
The SPDR XLU is the largest, with $20.3 billion in assets under management, and the cheapest of the three. However, the fund is top heavy, holding more than 50% of its weighting in its top 10 components, which is quite a lot considering it has only 34 holdings. In comparison, the Vanguard VPU fund is the most diversified, with 82 holdings. The iShares IDU fund also offers a diverse holding, but investors will have to fork over 0.47% in fees.
Investors may also consider international utility plays. Like other foreign stocks, these generate higher payouts than their U.S. counterparts. The iShares S&P Global Utilities (JXI) has an expense ratio of 0.48% and a 12-month yield of 4.86%. If you are already exposed to U.S. utilities, there are foreign-only plays that target utility companies outside the U.S, like the SPDR S&P International Utilities Sector ETF (IPU), which has a 0.50% expense ratio and a 5.59% 12-month yield; the WisdomTree Global ex-US Utility Fund (DBU), which has a 0.58% expense ratio and a 12-month yield of 5.06%; and the iShares MSCI ACWI ex-US Utilities Sector Index Fund (AXUT), which has a 0.48% expense ratio and a 9.32% 12-month yield.
The iShares Global Utilities fund has a 52% allocation to the U.S. If you are in need of greater country diversification, you may take a look at the other three international utilities offerings. Both the SPDR IPU and the iShares AXUT funds have high weightings in the U.K., Japan and Germany. The WisdomTree DBU ETF's top three country weightings include Brazil, the U.K. and Japan.
Lastly, investors may also look at equal-weight options like the Guggenheim S&P Equal Weight Utilities (RYU), which has a 0.5% expense ratio and a 3.48% 12-month yield, and the First Trust Utilities AlphaDEX Fund (FXU), which has a 0.70% expense ratio and a 1.91% 12-month yield. While the First Trust FXU ETF follows an equal-weight methodology, it is still slightly more top-heavy than the Guggenheim RYU fund. FXU holdings range from 0.5% to 4% whereas RYU stock holdings range from 1.4% to 2.8%.
Full disclosure: Tom Lydon is a board member of Guggenheim Investments.