Defend Yourself With A Utility ETF

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Includes: IDU, VPU, XLU
by: Jonathan Prather

Summary

Utility stocks are good defensive bets that provide steady dividend payments during periods of market uncertainty.

ETF structure provides diversification and safety from single stock risk.

The best ETFs have high quality AUM, low expense fees, and high trading volume.

We have undeniably entered a period of unprecedented uncertainty in global markets. The Dow continues to flirt with that magic 20,000 number, and come Jan 20th - Donald Trump will become the 45th President of these United States.

I think it is plausible we experience a market correction in 2017. I won't get into the "why's" because that is beyond the scope of this article. However, if you buy into this idea, then it would be worth looking into defensive stocks. One sector that performs decently, regardless of market conditions, is the utilities sector.

Enter Utilities

Utilities such as water, electric, and gas are staples of modern society. Utility services are often the last service foregone when a consumer experiences financial difficulty. For example, an average American under financial distress would more likely forgo purchasing a new car before giving up hot running water (though I'm sure there are exceptions). I should qualify this by mentioning that people are generally more conscious of how they consume utility services when they face financial difficulties. This is done in an effort to reduce personal expenses. Very few people however will discontinue using utility services altogether until there is no alternative available, so utility companies can expect steady cash flows largely independent of wider market performance.

Utility Companies

Utility companies carry heavy amounts of debt because they require large infrastructure investments. Because of their reliance on debt, the primary risk in investing in utilities companies is interest rate risk.

Income opportunity provides an attractive and unique incentive for potential investors. Utility companies can project out their future cash flows with high levels of certainty. Utility companies use this advantageously to pay large predictable dividends to their shareholders. Utility companies usually avoid dividend cuts at all costs, so the likelihood of losing out on future income is very low.

For these reasons: market stability, high dividend yields, certain cash flows, potential capital appreciation, and low stock volatility - I believe investing in the utilities sector is a sound defensive decision.

Comparing ETFs

The best ETFs are comprised of a well diversified bundle of high quality companies, with low expense ratios, high trading volume, and significant asset (generally at least $250MM). Under these specifications, the best utility ETFs are:

  • iShares U.S. Utilities ETF (NYSEARCA:IDU)
  • Utilities Select Sector SPDR Fund (NYSEARCA:XLU)
  • Vanguard Utilities ETF (NYSEARCA:VPU)

Each of these ETFs have outperformed the market in the last year.

iShares U.S. Utilities ETF

IDU returned 13.67% over the past 12-months, significantly higher than the underlying index. IDU's expense ratio, .44% is relatively cheap; however, it is significantly higher than both XLU and VPU. IDU is highly traded and has an attractive 3.18% 12-month yield. IDU also has over $700MM assets under management, and its holdings are predominantly large cap, deep value stocks.

While IDU is a decent pick, it is not the best ETF on the market.

Utilities Select Sector SPDR Fund

XLU provides broad defensive exposure to the utilities sector. The lion's share of its holdings are based in large, U.S., deep value utilities companies. It is one of the most heavily traded utility ETFs on the market, and its 0.14% expense ratio is well below the industry average 0.48%. XLU has nearly $7 billion in assets under management which allows it to maintain lower costs at scale as well as proportional diversification across the utilities market. Finally, XLU's attractive 3.28% SEC yield allows for steady income distributions.

XLU only performed .04% better than the index over the past year. Because it is one of the most scrutinized, least volatile, and most traded utility ETFs on the market - it is probably the safest option of the three utility ETFs I am covering.

Vanguard Utilities ETF

Vanguard tends to structure the most attractive ETFs on the market. VPU is no exception. VPU has $2.3 Billion AUM and an incredibly low 0.10% expense ratio. It has acceptable volume and will not run into any notable liquidity risk. VPU's SEC yield is a remarkable 3.42% (.14% better than its competitor XLU).

At 14.51% VPU significantly outperformed the index and its competitors over the past 12-months. The risk of VPU comes from its underlying holdings. VPU holds slightly more mid-cap stocks than XLU. In this instance, there is only a marginal increase in underlying risk. In my opinion, VPU is the best utilities ETF on the market.

Conclusion

Utilities stocks are good defensive plays with attractive dividend yields. ETFs provide attractive diversification across the market that enables investors to diminish single stock risk. Of the available ETFs on the market, VPU is the lowest expense, highest yielding, and best historically performing choice on the market. Therefore, investing in VPU is clearly the best option if you want to take a defensive position in the utilities sector.

Disclosure: I/we 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.