Investors who believe volatility may persist through the year and the Federal Reserve may hold off on quick interest rate hikes may want to take a second look at defensive utilities sector exchange traded funds.
“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,” writes Morningstar equity strategist Robert Goldsborough.
The utilities sector fundamentals remain strong. However, utilities have been underforming due to the sector’s inverse relationship to rising interest rates – when rates rise or investors fear higher rates, utilities typically underpeform, and vice versa.
Most investors view utilities as a reliable, income-generating asset that exhibit some bondlike characteristics. As interest rates declined, the sector appealed to many income investors for its relatively higher yields. For instance, the Utilities Select Sector SPDR (NYSEArca: XLU), the largest utilities sector ETF play, has a 3.67% 12-month yield.
However, as interest rates rise, yield investors will likely sell riskier dividend-yielding equities, like utilities, for more attractive fixed-income securities. Moreover, higher rates means utilities will face stiffer borrowing costs to fund growth, which would dampen earnings.
Consequently, with global volatility elevated and U.S. growth slowing down, many believe the Federal Reserve may follow a more gradual interest rate hike schedule. Without the Fed to support higher Treasury yields, utilities may have a chance to turn around this year.
XLU, the largest of the utilities ETF, tracks the S&P 500 utilities sector and is top heavy with over 60% of assets in its top 10 holdings.
Given the homogeneous nature of the utilities space and that most utilities ETFs track cap-weighted indices, the various ETF options have very similar track records.
Nevertheless, there are some slight differences that investors can still jump on. For instance, Vanguard Utilities ETF (NYSEArca: VPU) is the cheapest with a 0.10% expense ratio. VPU also includes a broader group of utilities companies, including more small- and mid-cap exposure. The ETF has a 3.63% 12-month yield.
For more alternative indexing methodologies, the First Trust Utilities AlphaDEX Fund (NYSEArca: FXU) selects components based on growth factors including three, six and 12-month price appreciation, sales to price and one year sales growth, and, separately, on value factors including book value to price, cash flow to price and return on assets. FXU has a 3.90% 12-month yield.
Additionally, the Guggenheim S&P Equal Weight Utilities ETF (NYSEArca: RYU), the equal-weight equivalent of XLU, has a 3.67% 12-month yield.
Max Chen contributed to this article.