Leading up to the Federal Reserve raising interest rates last month, the first such move by the U.S. central bank in nearly a decade, utilities stocks and exchange-traded funds were widely seen as vulnerable to higher U.S. borrowing costs.
Historical data confirms that utilities stocks are the most negatively correlated to rising U.S. interest rates, and as such, they typically lag during rising rates environments. Last year, utilities finished as the third-worst performing sector in the S&P 500.
The Surprising Durability Of Utilities ETFs
But in what may be a surprise to some investors, utilities ETFs have been durable over the past month, a period that includes the aforementioned interest rate hike. Over that time, the Utilities SPDR (ETF) XLU and the Vanguard Utilities ETF VPU, the two largest utilities ETFs, are up nearly 3 percent.
“Instead, investors should closely determine their own outlook for interest rates as well as these firms' fundamentals and then act accordingly. Considering that in 2014 the sector delivered double the return of the S&P 500, there's no question that the utilities sector is now reeling. For investors who hold a contrarian view on the U.S. Federal Reserve's future actions on interest rates, a utilities-sector investment could make some sense,” according to a recent Morningstar note.
Another utilities ETF that has impressed in recent weeks is the Reaves Utilities ETF UTES, the first actively managed utilities ETF. That fund is higher by nearly 4.8 percent over the past month. Reaves Asset Management, which has over $2 billion in assets under management, "relies on both qualitative processes (management interviews, field research, macro factor analysis) and quantitative processes (modeling, valuation, technicals) to inform investment decisions," according to the firm.
UTES offers another advantage for investors over other actively managed funds: daily disclosure of its holdings. Some issuers of actively managed products, including some wanting to wear the exchange-traded label, are maintaining an old Wall Street mentality, refusing to disclose their holdings on a daily basis.
“Despite weak electricity demand, the utilities sector's financial health remains strong. The sector's payout ratios are strong (about 60 percent) and sustainable, there are no imminent threats of dividend cuts, and there are good growth opportunities. In addition, gas utilities are seeing meaningful demand growth as customers switch from other heating sources to natural gas,” added Morningstar.
Sustainable dividends are critical to the allure of ETFs such as XLU and VPU. The average trailing 12-month dividend yield on those ETFs is 3.65 percent, explaining why income investors have widely embraced utilities ETFs as bond proxies.Image Credit: Public Domain
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