If The Fed Cooperates, Utilities ETFs Are Still Alluring

Really, it is a simple story. Speculation increases about the Federal Reserve raising interest rates and utilities stocks and the relevant exchange traded funds suffer. September rolls around and the Fed eschews a rate hike, leaving bond traders to surmise that the central bank could delay higher rates as far off as mid-2016 or that the Fed has missed the rate hike window altogether.

Investors' treatment of utilities ETFs underscores the role the Fed plays in determining this sector's fortunes. In the third quarter, the Utilities Select Sector SPDR XLU, the largest utilities ETF, hauled in $881.4 million in new assets and a fair chunk of that total arrived late in the quarter, after the Fed's September meeting. 

“Like most ETFs that invest in utilities companies, XLU pays a healthy yield. The fund's yield is currently 3.8%, and during the past few years it has averaged around 4%,” according to a new Morningstar research note. 

While XLU's 3.8 percent dividend yield today is below the four percent long-term average, the ETF's current trailing 12-month yield is still more than 170 basis points in excess of the yield on 10-year U.S. Treasurys.

“Long viewed as bond substitutes, utilities tend to generate stable cash flows and attractive yields. There is a long-standing relationship between interest rates and utilities' performance relative to the rest of the market. When rates rise or investors fear higher rates, utilities tend to underperform. During a low-rate environment or when rates are falling, utilities tend to outperform. If rates rise, Morningstar's equity analysts project flat returns for utilities and underperformance relative to other U.S. equity sectors,” according to Morningstar.

There is a new option to consider among utilities ETFs, the actively managed Reaves Utilities ETF UTES, which debuted in late September. 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 is the first actively managed utilities to come to market in the U.S. and although the new ETF's 0.95 percent annual fee is high compared to traditional index-based ETFs like XLU, UTES' costs compare favorably with actively managed utilities sector mutual funds.

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. That is not the case with UTES as investors can see the new ETF's holdings updated daily as is the case with most traditional, passive ETFs.