Valuation Concerns Could Hamper Utilities ETFs

Give the Utilities SPDR (ETF) XLU some credit. The largest exchange-traded fund tracking the utilities sector rose more than 0.66 percent Monday after Goldman Sachs downgraded the sector to Cautious from Neutral, citing valuation concerns.

Even amid what could be seen as a challenging interest rate environment, XLU is up 10.6 percent year to date. On a historical basis, no sector is as inversely correlated to rising Treasury yields as is the utilities sector. The high dividend yields on XLU and rival utilities ETFs make the sector and the corresponding funds vulnerable to rising rates. XLU currently yields north of 3 percent on a trailing 12-month basis.

“With the utility sector index roughly 10% higher than YE 2016 levels and having outperformed the S& 500 by 1% (excluding dividends) and 2% (including dividends), we become bearish on valuation,” said Goldman Sachs analyst Michael Lapides in a note out Monday.

Further Examining XLU

The $8 billion XLU tracks Utilities Select Sector Index and holds 30 stocks. In addition to its juicy dividend yield, XLU attracts conservative investors because the sector is defensive and seen as lower beta relative to the broader market. XLU's defensive posture also underscores the no free lunch proposition found with the utilities sector, meaning investors pay up on valuation for the privilege of getting defensive with utilities.

As Benzinga reported Monday: “Absolute PE ratios in the utility sector are back at peak cyclical levels, and relative valuation metrics compared to the rest of the S&P 500 are also near peak levels, Lapides wrote in the downgrade note. Finally, despite the outperformance in the market, earnings growth remains in the typical range.”

Additionally, XLU's defensive reputation can be deceiving. Over the past three years, the ETF's average annualized volatility of 15.3 percent is above the 12.9 percent found on the S&P 500.

Some Good News

Goldman did upgrade shares of Duke Energy Corp DUK to Buy from Neutral with an $85 price target. Duke is XLU's second-largest holding at 8.3 percent of the ETF's weight.

While it remains to be seen how many, if any, investors depart XLU based on valuation, the ETF has been sturdy this year when it comes asset flows. Investors have been overtly supportive of the fund, adding more than $510 million in new money to XLU year to date.

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