Tread Cautiously In The Overvalued Utilities Sector

| About: Vanguard Utilities (VPU)

By Robert Goldsborough

Utilities companies have made up significant ground this year after trailing the broader U.S. equity market by a wide margin in 2013. A broad utilities-oriented exchange-traded fund, Vanguard Utilities ETF (NYSEARCA:VPU), has returned 14.5% year to date, versus the S&P 500 Index's 7.7% return during the same interval.

Utilities companies' fundamentals have remained strong. Most utilities have strengthened their earnings profiles and balance sheets by taking advantage of low-cost borrowing and rich market prices. The utilities sector's average dividend yield remains near 4%, which is nearly double the market's average yield and some 130 basis points above the 10-year U.S. Treasury yield. We see no wholesale threats to dividends across the sector. Not surprisingly, investors in utilities companies keep a close eye on interest rates. With Treasuries remaining near record lows, investors have rewarded utilities companies.

Right now, Morningstar's equity analysts view utilities companies as being slightly overvalued. Indeed, VPU trades at 106% of Morningstar's equity analysts' estimate of fair value. However, for investors who remain bullish on utilities companies, there are several dynamics ahead that would be captured by VPU.

First, a recent rebound in power and natural gas prices boosted earnings for power producers. In fact, after a brutal winter, forward power prices and natural gas prices in the Mid-Atlantic region climbed 18% between January and May 2014, boosting the earnings of utilities with wholesale generation fleets in the Eastern United States. If power prices continue to rise, utilities companies could surprise to the upside.

As noted above, another dynamic affecting the utilities sector is interest rates. Since 2000, when interest rates began a secular decline, utilities companies have seen their investor bases broadened by those also seeking price appreciation in addition to income generation and reliability. Now, Morningstar's equity analysts believe that investors currently are pricing in 4% U.S. Treasury yields, so we don't expect substantial moves downward from utilities if rates hit that level. At the same time, another way utilities companies could continue their recent outperformance would be if Treasury rates stabilized close to 3%.

Still another dynamic worth watching is environmental regulation and litigation. On the legal front, the U.S. Environmental Protection Agency recently won two important court cases supporting their regulations limiting certain noncarbon coal plant emissions. The rulings have been prompting utilities to shut down older, inefficient coal plants. Further environmental regulation could actually be a boost for diversified utilities and independent power generators in the coming years, because newer rules and more shuttered plants could result in power shortages and higher power prices.

For investors seeking to invest in a basket of utilities companies, Vanguard Utilities ETF is a solid choice. VPU offers exposure to regulated utilities, diversified utilities, and unregulated power generators and is a suitable satellite holding for investors seeking defensive exposure to the U.S. equity market and dividend income. The fund is currently yielding 3.6%, and during the past few years, its yield has averaged around 4.0%. This ETF also can serve as a tactical bet on low interest rates and long-term growth in electricity demand.

VPU's volatility is low. During the past five years, this ETF's volatility of return of 10.8% is lower than the 13.4% that the S&P 500 Index has experienced.

Portfolio Construction
The fund tracks the MSCI US Investable Market Utilities 25/50 Index by owning every stock in the index. This benchmark includes all companies that have a GICS utilities sector classification from the MSCI US Investable Market 2500 Index, which represents 98% of the total U.S. stock market. The index provider follows a modified cap-weighting approach that limits individual constituents to 22.5% of the portfolio. Additionally, the combined weight of all companies over 4.5% may not exceed 45% of the index. This cap-weighting approach allows funds that track this index to conform to IRS requirements that allow them to receive favorable tax treatment. While it's not surprising that large caps represent the majority of the fund's assets (53.5%), mid-caps also represent a significant chunk of the portfolio (38.0%). As a result, the portfolio's average market cap is only $15.6 billion. Top subindustry weightings belong to electric utilities (52.5%), diversified utilities (33.5%), and gas utilities (6.5%). Independent power producers and energy traders only account for 4.8% of the portfolio, while water utilities are just 2.5%.

The fund charges a reasonable 0.14% expense ratio, which is lower than its closest peer of any size. Partially as a result of its low fees, VPU has tracked its benchmark closely since inception.

Utilities Select Sector SPDR (NYSEARCA:XLU) is a more liquid, though less diversified, alternative. It invests in all 30 utilities companies in the S&P 500 Index. This approach gives XLU a stronger large-cap tilt and more concentrated portfolio than VPU. XLU's top 10 holdings account for nearly 59% of its portfolio. Despite its more concentrated portfolio, XLU has not experienced significantly greater volatility than VPU during the past five years. During that period, these funds were nearly perfectly correlated. While XLU's 0.16% expense ratio is comparable to VPU, its asset base and trading volume are substantially higher, which tends to make it a better option for large traders. XLU also offers a more attractive dividend yield.

iShares U.S. Utilities (NYSEARCA:IDU) is a more expensive alternative. Its fees take a 0.44% bite out of the fund's returns each year. For this hefty price, investors get a portfolio of 62 large-, mid-, and small-cap stocks in the Dow Jones Utilities Index. However, more than 95% of IDU's assets overlap with VPU. IDU also has fewer assets than VPU.

A recently launched and very inexpensive option is Fidelity MSCI Utilities Index (NYSEARCA:FUTY), which charges 0.12%. However, FUTY has far fewer assets than its other market-cap-weighted utilities ETF peers and is thinly traded. FUTY tracks a slightly different index from Vanguard Utilities ETF; FUTY tracks the MSCI USA IMI Utilities Index, while VPU tracks the MSCI US Investable Market Utilities 25/50 Index. Fidelity customers with a minimum balance of $2,500 can buy FUTY commission-free, although they are subject to a short-term trading fee by Fidelity.

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.

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