The Utilities Select Sector SPDR (NYSEArca: XLU), the largest exchange traded fund tracking the utilities sector, higher by more than 6% to start 2017.
Against the backdrop of potentially higher interest rates, perhaps as soon as this month, some investors are pensive about the rate-sensitive utilities sectors and ETFs such as XLU.
However, some see more upside coming for utilities stocks. Once the Fed eventually hikes interest rates, the higher rates will make fixed-income instruments more attractive on a relative basis, and bond-like equities, like utilities, less enticing. Consequently, utilities may remain flat or underperform other segments of the equities market once rates start ticking higher.
No sector is as negatively correlated to rising interest rates as utilities, meaning the longer the Fed resists raising interest rates, the longer high-yielding utilities stocks and ETFs remain compelling destinations for yield-starved investors.
“What’s even more interesting is that utilities continued to fall even after Donald Trump won and the so-called “Trump rally” began. Utilities only really began to recover in full at the start of 2017, meaning utility investors are sitting on 20% gains from the start of 2016 to today, excluding dividend payouts,” reports ETF Daily News.
Investors looking for smart beta alternatives to XLU and other cap-weighted utilities ETFs can consider the First Trust Utilities AlphaDEX Fund (NYSEArca: FXU).
Like the other AlphaDEX funds, FXU is “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,” according to First Trust.
Utilities stocks and ETFs are extremely sensitive to changes in interest rates. Still, some investors see opportunity with rate-sensitive assets such as FXU and real estate ETFs, noting that 10-year yields are overbought and sentiment against the likes of FXU is at bearish extremes, which could create opportunity from the long side with the utilities sector.
Analysts warned that the lofty prices may not be supported by robust earnings growth. Investors can tap the potential potency of earnings growth via FXU’s methodology at an earnings multiple that implies a slight discount to the broader utilities sector.
For more information on defensive ETFs, visit our defensive ETF category.