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By Robert Goldsborough

Many investors have been drawn to the utilities sector over the last decade-plus, as utilities companies have benefited from strong residential and commercial demand for electricity and have enjoyed cheap debt financing to fund capital projects. In addition, utilities companies benefit from a declining-interest-rate environment, which can boost firms' profitability because regulated rates of return are not frequently adjusted by regulators. Also, investors have viewed utilities companies almost as a hybrid between bonds and stocks--they can't offer the same growth as equities, but nonetheless they are very stable and very appealing because of their dividend yields. Since interest rates began their secular decline in 2000, utilities have produced nearly double the S&P 500 Index's total return.

Now an inflection point looms. At the start of May 2013, utilities companies' stock prices went into a tailspin and utility company valuations compressed as investors began to become spooked about sharply higher Treasury rates. Utilities have a long history of underperforming the broader market when interest rates rise. If they do rise, Morningstar's equity analysts see flat returns ahead for utilities and underperformance relative to other U.S. equity sectors. Obviously, predicting interest-rate movements is highly speculative. And offering more uncertainty right now is the upcoming change in the Federal Reserve Board chairmanship and what impact that might have on quantitative easing programs.

For contrarian investors who are not dissuaded by the currently rich valuations in the utilities sector, an exchange-traded fund we recommend is Utilities Select Sector SPDR (NYSEARCA:XLU). The oldest and largest utilities sector ETF, XLU offers exposure to regulated utilities, diversified utilities, and unregulated power generators (which account for a small portion of the portfolio) by holding every utilities company in the S&P 500 Index. XLU is a suitable satellite holding for investors seeking defensive exposure to the U.S. equity market and dividend income (its yield is 3.9%). It also could serve as a tactical bet on low interest rates and long-term growth in electricity demand.

Investors should note that, according to Morningstar's equity analysts, XLU currently trades at 104% of the fair value of its weighted holdings, compared with the S&P 500 Index, which trades at 100% of its fair value.

Fundamental View
Interest rates historically have had a major impact on utilities companies, which tend to outperform other equity sectors in declining-rate environments or low-rate environments. Generally, the higher the yield spread--the difference between utilities companies' dividend yield and 10-year U.S. Treasury rates--the better it is for the price performance of utilities companies. The yield spread has compressed from nearly 300 basis points in June 2012 to about 200 basis points now. That compression has concerned investors, who have punished utilities companies. Thus far in 2013, the utilities sector has underperformed not just the S&P 500 Index but every other U.S. equity sector as well.

Morningstar's equity analysts have looked at decades of historical data and concluded that even if interest rates rise to 4%, investors still could see solid, if unspectacular, absolute returns from utilities companies. However, outperformance would not be likely. For outperformance to take place, rates would need to decline or at least flatten.

Another area of concern for regulated utilities companies relates to the target rates of return set by regulators. In several recent rate cases, regulators have set relatively low rates of return for the affected utilities. If that trend continues across the sector, the combination of reduced target rates of return and rising interest rates could pressure utilities companies' earnings.

Another issue worth watching closely is electricity demand. Although the economic recovery has been ongoing, U.S. retail electricity demand actually remains 3% below its 2008 peak. Industrial demand has been particularly low. In addition, some states' energy-efficiency standards have been having an impact on power demand.

On the positive side, a number of large regulated utilities have been making significant capital expenditures, which could drive rate base and earnings growth in the coming years. Also, some of the larger utilities companies, such as Duke Energy (NYSE:DUK), Southern Co. (NYSE:SO), and Dominion Resources (NYSE:D), operate in the Southeast, where population has been increasing--which is a cheap and easy way for regulated utilities to grow--and the regulatory environment generally is favorable.

Portfolio Construction
XLU tracks the S&P Utilities Sector Select Index by investing in all 31 utilities companies in the S&P 500 Index and weights these holdings in proportion to their float-adjusted market capitalization. S&P's cap-weighting approach limits individual positions to 19% of the portfolio, though XLU's largest holding falls well below that mark. Electric utilities represent more than 56% of the portfolio, but diversified utilities also have meaningful weigh (37%). Gas utilities and independent power producers and energy traders each only account for about 3% of the portfolio. Because of its limited number of holdings, the portfolio is highly concentrated. The top-10 holdings soak up more than 57% of the fund's assets. Additionally, its holdings only account for 3.3% of the total assets in the S&P 500. XLU has consistently landed in the deep-value zone of the Morningstar Style Box.

The fund charges a reasonable 0.18% expense ratio, making it the second-lowest-cost utilities fund available. Both the fund and its holdings are liquid, which keeps its bid-ask spread tight and minimizes deviations from net asset value. State Street engages in share lending, the practice of lending out the fund's underlying shares in exchange for a fee. It passes 85% of the gross proceeds to investors, which partially offsets the fund's expenses.

Investors looking for slightly broader diversified exposure to the utilities sector should consider Vanguard Utilities ETF (NYSEARCA:VPU). VPU extends its reach further down the market-cap ladder and rests on a broader base of 79 stocks. Despite its better-diversified portfolio, VPU exhibited comparable volatility to XLU over the past five years. VPU's 0.14% expense ratio is less than XLU's, but the Vanguard fund is approximately one fourth its size, which may give it a wider bid-ask spread. Over the past three years, VPU and XLU were nearly perfectly correlated.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Slow Growth, But A High Dividend And Low Volatility: Our Favorite Utilities ETF