As an “old economy” sector, utilities are notable for their steady revenue streams. They also typically serve as a defensive segment of a portfolio. But recent trends in artificial intelligence have helped propel growth in this sector — including using utilities as a thematic play. This note explores the utilities sector, its demand drivers, and several ETFs for investors to choose from.
Performance Has Caused Investors to Take a Closer Look at the Sector
The utilities sector is up 25.9% year-to-date, which is the most out of any sector in the S&P 500. It has also received a healthy amount of net inflows — especially over the past three months.
On an equal-weight basis, the utilities sector is still the top-performing sector with an even wider gap between its peers. The sector has had positive net inflows, while its other peers have had net outflows.
Either way you look at it, utilities have done well this year. This has caused many investors to look more closely at the sector — what has been driving the growth?
Utilities Sector Overview: Defensive Sector With Growth Opportunities
Large-cap utilities companies aren’t necessarily household names (ironic because these are the companies that power your household). Utilities companies include electric, water, and gas utilities. Companies in the utilities sector are known for several key benefits:
- Consistent demand: utilities are essential services that are needed throughout economic cycles
- Pricing power: because utilities are essential, they can more easily pass on costs of inflation to the consumer
- Low volatility with attractive dividends: the sector doesn’t typically generate significant returns but tends to have smaller losses during downturns (e.g., 2018 and 2022)
These are great defensive characteristics, but that still doesn’t answer the growth question. Let’s look at some of the holdings to see why.
Watch Out Tech Stocks, Utility Stocks Have Also Been Benefiting From AI Boom
The fourth largest stock in the sector, Constellation Energy (CEG), has contributed significantly to sector performance. It has risen over 116% YTD. The company recently signed a deal with Microsoft (MSFT) to provide it with clean (nuclear) energy for its cloud computing and AI data centers.
Another company that contributed significantly to the sector is Vistra Corp (VST), which is up almost 192% YTD. Like Constellation Energy, Vistra has received attention for its nuclear power business in relation to AI data centers. Interestingly, Vistra is currently the top-performing stock in the S&P 500. For reference, Nvidia Corp (NVDA) is now the second-best performing stock, with a 144% gain YTD. Will we see single-stock Vistra ETFs now? It’s unlikely, but it’s interesting to see a utility stock beat Nvidia’s performance (even if it may not be long erm).
The largest company in the sector by market cap is Nextera Energy (NEE), an electric power and energy infrastructure company. While demand for utilities has held relatively steady, Nextera forecasts that power demand will likely grow four times faster over the next two decades compared to the prior two.
An Active Sector ETF — Playing on AI
The Virtus Reaves Utilities ETF (UTES) can seem underwhelming at first glance. The fund only has $178 million in assets and has about $97 million in net inflows YTD. But it has returned over 40% YTD while its peer sector utilities funds have only returned around 25%. UTES is actively managed (not very common with sector ETFs). Its holdings aren’t very different from its peers (XLU, for instance), but its weightings are significantly different. Because UTES uses active management, it can focus on holdings like Constellation Energy and Vistra Corp. These are the second and third largest holding, respectively. While market-weighted utilities ETFs hold Constellation in their top 10 holdings, Vistra is much smaller and has less weight.
Besides UTES, here are some other ETFs within the utilities sector:
- The Utilities Select Sector SPDR Fund (XLU): This fund is the oldest, largest, and one of the cheapest among its peers. It tracks the Utilities Select Sector Index, which consists of S&P 500 components within the utility sector. If any component has a fair market capitalization of greater than 24%, its weight is capped at 23%. That provides a 2% buffer to meet RIC diversification guidelines. With only 34 holdings, that puts this ETF on the lower end of holdings among its peers.
- The Vanguard Utilities ETF (VPU): This is also a low-cost, index-based fund that tracks the MSCI US Investable Market Utilities 25/50 Index. This index is a benchmark of large-, mid-, and small-cap stocks. This contrasts with XLU, which consists of only large-cap S&P 500 constituents.
- The iShares U.S. Utilities ETF (IDU) shares similarities with its peers above. It focuses on the utilities sector of the Russell 1000 (a large-cap index). There are some slight differences in holdings that stem from a classification divergence of industrials and utilities. IDU, for example, holds Waste Management (WM) as its fourth largest holding (classified as an industrial stock under GICS), which is not found in XLU, VPU, RSPU, or UTES.
- The Invesco S&P 500 Equal Weight ETF (RSPU): Like XLU, this fund also tracks the utility sector of the S&P 500, except an equal-weighted version. This year, RSPU was at a disadvantage since stocks in the sector broadly performed well. Only two stocks were negative performers — AES Corp (AES) and Centerpoint Energy (CNP), which were down only 1.8% and 1.4% YTD, respectively. Equal-weight ETFs, however, have advantages for diversifying risk. In recent years when the total market was down (2018 and 2022), RSPU outperformed XLU.
Will We See Related Funds in the Future?
I often talk about sector, industry, and thematic ETFs under a similar lens. Two issuers that are big in the thematic space — Global X ETFs and Tema ETFs — have both filed for electrification ETFs this months (see filing here and here). These ETFs will likely have exposure to similar utilities stocks. But I believe these will likely be thematic plays with AI as an underlying growth driver, rather than industry plays.
Regardless, it’s significant to see how the market connects and how large trends are rarely isolated. New trends can help propel old industries, while old industries can help support new trends.
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