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Another Fed Test For Utilities ETFs

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Another Fed Test For Utilities ETFs

Solidifying the notion that boring can be beautiful, the utilities sector and its relevant exchange-traded funds are acting like the NASDAQ of the 1990s. Well, that is hyperbole, but the Utilities SPDR (ETF) (NYSE: XLU) is up 12.5 percent year-to-date.

Utilities ETFs And The S&P

Additionally, XLU and rival utilities ETFs are, as they should be, less volatile than the S&P 500. While delivering five times the returns of the S&P 500 this year, XLU has also been 130 basis points less volatile than the benchmark U.S. equity index.

Related Link: What Negative Rates Are Doing To Financial Services ETFs

Utilities And The Fed

However, investor enthusiasm for XLU and ETFs such as the Vanguard Utilities ETF (NYSE: VPU) and Fidelity MSCI Utilities Index ETF (NYSE: FUTY) could be tested if the Federal Reserve follows through on its plans to boost interest rates at its June meeting.

Remember last year when all the speculation about higher interest rates led to all of one rate hike that did not arrive until December. That was enough to send FUTY, VPU and XLU to annual losses of nearly 5 percent apiece, making utilities 2015's third-worst performing sector. Historical data confirm that utilities stocks are the most negatively correlated to rising U.S. interest rates, and as such, they typically lag during rising rates environments.

Just How Risky Are Utilities ETFs?

Other data points support the theory that utilities ETFs could be risky near-term bets.

“Generating insatiable investor demand, the US utilities sector continues to outperform but as yields compress to below those of high grade corporate debt, the segment may have reached its peak,” said Markit in a recent note. “Investors have been attracted to the sector by the relative safety of business characteristics (dependable cash flows) but also the sector’s attractive dividend yields. Underpinning yields is strong dividend growth currently forecasted of 5.7 percent for 2016, outpacing the S&P 500’s expected average growth of 3.6 percent.”

A Closer Look At The Biggy

XLU, the largest utilities ETF, yields 3.32 percent on a trailing 12-month, well above the dividend yield on the S&P 500, the yield on 10-year Treasurys and what investors will find on many investment-grade corporate bonds.

Related Link: Yes, Smart Beta ETFs Are For Real

Further increasing potential near-term vulnerability for the utilities is that it has become something of a hedge fund hotel as evidenced by massive year-to-date inflows to the aforementioned ETFs.

On its own, XLU has added $1.39 billion in new money while investors have plunked down a combined $512 million into VPU and FUTY.

Falling yields, despite continued growth in underlying dividend payments, indicate that there is considerable investor demand for the asset class in the current low interest rate environment. While the yield on average in 2015 was higher than 2014, the thirst for income has seen the sectors’ yield once again fall,” added Markit.

 

Related Articles (XLU + FUTY)

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