This ETF Offers A Bastion Of Stability In An Uncertain Market

May.10.12 | About: Utilities Select (XLU)

By Abraham Bailin

The level of uncertainty that has proved itself pervasive in today's market has yet to abate. The end result in the minds of many has been to seek out relative stability. While some of the more niche asset classes like master limited partnerships have garnered interest on this basis, it is the utilities sector that is consistently turned to as a bastion of safety within the equity markets. The perception does not miss the mark. The utilities space has posted a three-year standard deviation measure of roughly 10, whereas the S&P 500 posted a much higher metric of nearly 15 over the same period.

The most contentious issue surrounding the utilities space today is the persistently low price of natural gas. Persistence of low prices is likely to cut into the margins of the unregulated non-natural gas (that is, coal-powered) utilities. That said, within the context of a well-diversified utilities investment, unregulated natural gas utilities will likely see increases in volume that offset the effect to some degree. Here we discuss the industry and the mechanics of a broad utilities investment in greater detail and the products best suited to provide exposure.

An ETF for Investors Interested in Utilities
Given the Utilities Select Sector SPDR's (NYSEARCA:XLU) narrow sector focus, treat this as a satellite specialty holding. Investors buying this exchange-traded fund are getting exposure to both regulated utilities (which are known for operating stable businesses with predictable returns and dividends) and merchant power generators (companies whose profitability exhibits high variance because of commodity price swings). Motivations for holding XLU include a belief that our nation's electrical infrastructure requires substantial investment, that utilities will continue to be able to tap capital markets effectively, that natural gas prices will not decline, and that electricity demand will continue rising over the long run. This multifaceted thesis is indicative of the many drivers upon which this fund's performance hinges.

Investors holding XLU have historically received generous dividends quarterly, and the fund has generally moved in the same direction as the overall market, albeit with smaller gains and retreats. Broad domestic indexes, like the S&P 500, typically carry a utility weighting of around 2%-4%, a figure that investors should consider when using this fund as a complement to an established core portfolio. Moreover, the fund's 0.18% expense ratio is low even by ETF standards, making it the cheapest utility sector fund available.

A Closer Look at the Fundamentals
Despite the plodding nature of utilities, their stocks do swing in and out of favor. During the market crash in late 2008, utilities fell with the broader U.S. market. Utilities dropped just more than 11% in the last quarter of 2008, while the S&P 500 fell nearly 22%. Since then, the broad utilities space has realized a 41% gain, while the broader S&P 500 increased by nearly 67%.

One of the primary drivers of the utilities space is commodities prices, specifically natural gas. Natural gas prices have significant influence on the unregulated portion of the utility industry. Peaking power plants, natural gas plants that maintain grid stability during periods of high energy usage, set electricity prices for most other market participants like coal and nuclear plants. The beneficiaries of price run-ups are the existing coal, hydro, and nuclear plants, whose costs remain low as their margins increase dramatically. Today, however, we have quite the opposite scenario, as natural gas prices sit at historically low levels.

Another major driver of utilities is the market cost of capital--interest rates, access to loans, and the ability to issue equity at a decent price. Utility projects are very capital-intensive. Both power plants and transmission lines cost anywhere from hundreds of millions to billions of dollars to construct. Prior to the recent financial crisis, utilities companies had drawn up plans to make such substantial capital investments over the coming decade. At least over the near term, however, many of those projects will be put on hold until financing becomes less expensive. If commodity prices and electricity demand remain flat, utilities earnings growth will be difficult to achieve given the lack of available capital.

Regardless of capital availability, North American utilities will be forced to make substantial investments sometime within the next decade. Aging, fragmented, and capacity-constrained infrastructure needs to be refurbished and upgraded. This should eventually lead to considerable earnings growth for the sector, but we can't be sure of the timing of this trend.

Portfolio Construction
XLU owns and passively tracks the 32 utilities of the S&P 500 in proportion to their market-cap weightings. The fund includes constituents that run the gambit of utilities firms, but more than 55% of its holdings are electric utilities companies. The portfolio is top-heavy, with the top-10 names soaking up more than 55% of the fund. This is the oldest and largest utilities ETF on the market. It's also one of the more frequently traded ETFs focusing on stocks that fall in the large-deep value zone of the Morningstar Style Box.

This fund is by far the largest of the three market-cap-weighted U.S.-focused utility sector ETFs available. The Vanguard Utilities ETF (NYSEARCA:VPU) provides exposure to 84 companies and only maintains approximately 45% of its total assets in the top-10 holdings, but its fee is slightly higher at 0.19%. While VPU is an inexpensive and better-diversified alternative, it is also roughly seven times smaller than XLU. The next closest alternative is iShares Dow Jones US Utilities (NYSEARCA:IDU). Like the Vanguard fund, IDU offers broader diversification than XLU through its 74 holdings and a roughly 46% asset concentration in the top-10 holdings, but its 0.47% fee detracts from its appeal.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.