Safe Investing With 2 Utility ETFs And 1 Mutual Fund In 2014

Includes: IDU, PUI, RYU, UPW, VPU, XLU
by: Bruce Vanderveen

Boring? Yes! But sometimes, boring is good. With markets exhibiting a severe case of ADD so far this year (down 7% by February 3, then roaring back by Valentine's Day) many investors are getting a little more excitement than they would like.

What can be said is this: After a relatively tranquil 2013, volatility is back. A new Fed chairperson, Fed tapering, rising (or falling) interest rates, emerging market distress - it all points to a rollercoaster ride for the year ahead. Fasten your seat belts!

But, what to do if you're a conservative investor, and you don't want to go on a rollercoaster ride? Perhaps it's time to look for something safe, staid, and stable.

One place to look for stability is the utility sector. This sector weathers stormy and uncertain markets well. It tends to be conservative, low-beta, defensive, dividend paying, and, okay let's admit it, boring.

Since Utilities provide essential electric and gas services, their products are always in demand. Surprises, both good and bad, are relatively rare (but not impossible, as the nuclear accident at Three Mile Island showed us in 1979).

With funds (in this case utility funds), investors largely eliminate corporate risk - the risk of a large investment in a company which, for whatever reason, hits the skids. Funds usually hold dozens or more companies so risk is spread out and investors have much better downside protection than any one company can offer.

In recent years, easily traded and inexpensive Exchange Traded Funds (ETFs) have proliferated, and thousands are now readily available to investors. The utility sector alone has 22 ETFs. Below I profile two of the largest utility ETFs plus take a brief look at a natural gas fund, which, I believe, offers large capital gain potential.

Utilities Select Sector SPDR ETF (NYSEARCA:XLU), which tracks the Utilities Select Sector index basically mirrors the large utility stocks in the S&P 500. With $5 billion in assets under management, it's the largest utility ETF. The fund currently holds 32 of the larger U.S. utilities. XLU's three largest holdings are: Duke Energy (NYSE:DUK) at 9.6% of assets, NextEra Energy, Inc. (NYSE:NEE) at 8.2%, and Dominion Resources, Inc. (NYSE:D), also at 8.2%.

XLU is ideal for passive investors (those who have neither the time nor inclination to monitor their investments closely) and who wish safety, low-volatility, plus some income - XLU currently yields 3.75%. The annual expense ratio is a low 0.18%.

Not including dividends, XLU returned 55% over the last five years and 9.5% over the last 12 months.

Vanguard Utilities ETF (NYSEARCA:VPU) is quite similar to XLU. (Both ETFs have the same top 10 holdings.) However, with 78 holdings, VPU has a more diverse base. VPU, unlike XLU, holds many medium and small sized utilities. Over half of VPU's holdings are electric utilities. Multi-utilities (those providing more than one service - say electric and gas) make up about a third. The remainder are gas, water, and energy traders. VPU is also ideal for passive investors who wish a broad-based stake in the U.S. utility industry. The current annual yield is 3.66%

Not including dividends, VPU has had somewhat better returns than XLU with a five-year return of 67% and a one-year return of 10.7%. It is worth noting that Vanguard funds generally have low annual expense ratios and VPU, with a 0.14% number, does not disappoint.

Hennessy Gas Utility Index Investor (GASFX), a mutual fund, has over 60 holdings in natural gas related companies. About 60% of assets under management are utilities, with the balance being in energy related industries such as pipelines and other natural gas related infrastructure. (GASFX has 4.92% of its assets in Cheniere Energy, Inc. (NYSEMKT:LNG) which constructs natural gas export terminals.) GASFX's three largest holdings are: Spectra Energy Corp. (NYSE:SE) at 5.1% of assets, ONEOK Inc. (NYSE:OKE) at 5.0%, and Kinder Morgan, Inc. (NYSE:KMI) also at 5.0%. GASFX currently yields 2.13%.

Ever since the 2008-2009 fracking revolution dumped prodigious amounts of natural gas on North American markets (prices dropped from $12/MMBtu to $4 in under a year) gas prices have languished, mostly in the $2-$4 range. But in the last month and a half, thanks to the catalyst of cold winter weather, prices began to shoot back up. As I write, natural gas prices are now approaching $6/MMBtu, the highest since 2009.

It appears the industry has once again been caught flat-footed. Much to everyone's surprise, early January saw shortages suddenly pop up from California to New York. Prices spiked as high as $100/MMBtu in the New York area. Suddenly, those huge surpluses seemed to have vaporized.

Is it simply cold weather? Probably not. Although the cold is certainly a factor, demand from electric utilities and industry has ramped up in recent years while drillers, again because of low prices, have reduced the number of rigs drilling for gas and gas production has fallen off.

With gas prices on the upswing more money is flowing into the sector and GASFX's companies should benefit. Nothing unusual here, it's simply the law of supply and demand.

Not including dividends, GASFX has a five-year return of 130% and a twelve-month return of 17%. The fund has a 5 star Morningstar rating and a 0.70% annual expense ratio.

GASFX is a mutual fund, not an ETF. Mutual funds can usually be bought and sold through brokerages (TD Ameritrade has no commission charges for GASFX) but keep in mind transactions are only executed at the end of the business day at the closing price of that day.

Interest Rate Cautions

Interest rates are one of the big unknowns in 2014. In July of 2012 the U.S. 10-year treasury note rate reached a record low of 1.4%. It is now around 2.75%. As utilities are capital-intensive, rising rates have traditionally been viewed as a negative for utilities. As the next paragraph show us, however, the correlation recently seems to have broken down.

It is interesting to note (puns not intended) that as rates have risen since July 25, 2012 to the present, the iShares 7-10 Year Treasury Bond ETF (NYSEARCA:IEF) has, as expected, fallen in value (7%), but surprisingly the Utilities Select Sector SPDR ETF has gone up 9%. (See here.)

Considering that I expect interest rates to be mostly flat this year (primarily due to a slowing, disinflationary economy) utilities should be a safe investment in 2014.

Conclusion And Summary

Utility funds may indeed be boring, but they will likely provide investors with safety, income, and the possibility of capital gains in 2014.

XLU and VPU will appeal to passive investors for whom safety and income are paramount while GASFX, not only looks safe, but the fund appears to have the potential to reward investors with high capital gains as natural gas prices rebound.

In today's highly volatile market Utility ETFs may just be the place to be for investors looking for stability.

Disclaimer: This article is intended to be informational only and should not be taken as investment advice. Do your own due diligence.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long GASFX