Low Expectations for Utilities ETFs

ETF Trends

As a defensive sector depended on for dividends and perceived value over growth and alpha, utilities is not the place for adrenaline seekers.

With tapering of the Federal Reserve’s bond-buying program confirmed and interest rates expected to climb again next year, utilities exchange traded funds could come under pressure. Cumberland Advisors Chairman David Kotok thinks the seduction of yield will continue to be the enemy of capital gains in 2014, notes Jeff Macke for Yahoo’s Breakout.

Yields on ETFs such as the Utilities Select Sector SPDR (XLU), iShares U.S. Utilities ETF (IDU) and the Vanguard Utilities ETF (VPU) are attractive compared to nearly every other comparable ETF tracking another sector. However, investors have paid  price to get that yield and play defense. [Utility ETFs for Yield]

Over the past three years, utilities ETFs have not only lagged the S&P 500, but these funds have also been trounced by the returns offered by other defensive sectors. For example, the Consumer Staples Select Sector SPDR (XLP) is up 57% since Dec. 17,2010 while the Health Care Select SPDR (XLV) has surged 82.8% over that time.

It is not etched in stone that 2014 will be a down for the utilities sector, but expectations are in place that Treasury yields will rise again. Some economists think 10-year yields will to 3.2% or 3.3%. Utilities ETFs have already been exposed as rate-sensitive because higher rates mean higher borrowing costs that could threaten dividends. [Utilities ETFs are Saying Rates Will Rise Again]

“Investors will be quick to flee if they think there’s a possibility that a safer source of competitive yields is on the way,” writes Macke.

On top of higher interest rates, utilities are always faced with the specter of government regulation and then there is the fact that when energy commodities fall in price, utilities stocks do not benefit the same way that, say, airlines do.

“People who sacrificed growth to get an extra point or two of yield gave up 60 or 70 points over the last 4 or 5 years in relative performance. There’s no reason to think that relative performance is going to improve in 2014,” Kotok told Breakout.

Making the utilities situation all the more concerning is that investors will pay up for the privilege of being involved. The sector’s current 12-month forward P/E of around 15 is above its five- and 10-year averages.

That is to say XLU is pricier than the Financial Select Sector SDPR (XLF) and the Energy Select Sector SPDR (XLE) , just to name two.

Utilities Select Sector SPDR

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XLU

ETF Trends editorial team contributed to this post.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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