Finding The Right Utilities ETF

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Includes: FUTY, IDU, JHMU, UTLF, VPU, XLU
by: Evin Rohrbaugh

Summary

The utilities sector doesn't always move with the market but its higher average dividend yield attracts many income investors.

There aren't many ETF choices for this specific sector, and some of the passive funds are more speculative with customized multi-factor indices.

The only three funds that could be considered low-cost are XLU, VPU, and FUTY.

The utilities sector, known for its defensive qualities, is fairly popular for investors in both good and bad times. A major index for tracking the utilities sector in the U.S., the S&P 1500, has performed very closely to the S&P 500 as a whole. The sector has been soaring just as much as the rest of the market, and the average dividend yield in the sector is around 1% higher than the entire S&P 500 average yield.

If investors were searching for for defensive equities at the time of the 07 financial crisis, the biggest utilities ETF, the Utilities Select Sector SPDR ETF (NYSEARCA:XLU), dropped 30% at it's worst whereas the S&P 500 dropped over 45% at it's lowest during that period. A crash of that nature would obviously still cause panic selling, even in the defensive sectors. It doesn't take away from the fact that the utilities sector did basically perform as advertised by not dropping as much as the general market during the crash.

Active and Passive ETFs

Certain passive funds have their toes right up to the line of falling into active when the fund creates it's own factor-based index. It might not be day to day stock picking, but a complicated index that rebalances quarterly could easily be limiting their stock picking to only four times a year under the pretense of rebalancing an extremely specific index. I'm not accusing any funds of actually misleading, but a bit of a gray area has developed with some passive funds that might as well be considered to be actively managed.

The ETFs I'll be looking at today are all concentrated on the U.S. utilities sector, so I'll be excluding international and actively managed funds. Compared to other sectors and strategies, there aren't a ton of choices as far as utilities ETFs go, mainly due to the lack of diversity within the U.S. utilities sector. The geographical restrictions, barriers to entry, plus the heavily regulated nature of these companies keeps the number of total operators in the space inherently limited. So you'll likely notice some overlap of the holdings, particularly with the biggest companies.

Below is a look at the inflows and outflows over the past year for all six ETFs I'll be analyzing here, taken from this tool at etf.com.

I don't know what to attribute the large outflows from XLU to, but we can see an overall increase in capitalization from the top ten companies over the past year, seen below.

Company One Year Market Cap Current Market Cap
NextEra Energy (NYSE:NEE) $56.9 billion $69.4 billion
Duke Energy (NYSE:DUK) $52.2 billion $59.3 billion
Southern Company (SO) $48.1 billion $49.4 billion
Dominion Resources (D) $44.3 billion $49.2 billion
Exelon Corporation (EXC) $29.3 billion $36.5 billion
PG&E Corporation (PCG) $29.9 billion $35.2 billion
American Electric Power Company (AEP) $29.7 billion $35.2 billion
Sempra Energy (SRE) $25.5 billion $28.2 billion
PPL Corporation (NYSE:PPL) $21.6 billion $25.6 billion
Edison International (EIX) $22.7 billion $25.2 billion

The choices for ETFs in the utilities sector are rather small in number compared to other ETFs in the bigger and more popular sectors. The below table provides a comparison of the six ETFs chosen for analysis.

Fund

Yield

Expense Ratio

Total Assets

Benchmark

Number of Holdings

Commission-free trading

XLU

3.21%

0.14%

7.7 billion

S&P Utilities Select Sector

28

N/A

Vanguard Utilities ETF (NYSEARCA:VPU)

3.18%

0.10%

2.71 billion

MSCI USA IMI Utilities Index

76

Vanguard

iShares U.S. Utilities ETF (NYSEARCA:IDU)

3.04%

0.44%

838.66 million

Dow Jones Utilities Index

52

Fidelity

Fidelity MSCI Utilities Index ETF (NYSEARCA:FUTY)

3.05%

0.08%

310.95 million

MSCI USA IMI Utilities Index

75

Fidelity

John Hancock Multifactor Utilities ETF (NYSEARCA:JHMU)

2.41%

0.50%

20.09 million

John Hancock Dimensional Utilities Index

43

E*TRADE

iShares Edge MSCI Multifactor Utilities ETF (BATS:UTLF)

3.30%

0.35%

2.66 million

MSCI USA Utilities Diversified Multiple-Factor Capped Index

26

N/A

Typically when analyzing ETFs I scrape away the ones with the abnormally high fees first. The first fund I'll mention is UTLF. The expenses total 35 basis points, but my biggest issue is the multi-factor approach, which I feel identifies as one of those funds which is straddling the line between active and passive fund management. Even though it is marketed as passive, the quarterly rebalancing is done based on a very customized basis which brings in speculative elements that passive investing is usually meant to avoid. On this basis I could have excluded UTLF from my list entirely, but I wanted to mention it as an example of the active/passive issue mentioned earlier. This ETF is not simply a generic, passive mix of the US utility sector, the strategy is specific and below is a from UTLF's prospectus:

The Fund seeks to track the investment results of the MSCI USA Utilities Diversified Multiple-Factor Capped Index (the "Underlying Index"), which has been developed by MSCI Inc.(the "Index Provider" or "MSCI"). The Underlying Index is designed to select equity securities from the MSCI USA Utilities Index (the "Parent Index") that have high exposure to four investment style factors: value, quality, momentum and low size, while maintaining a level of risk similar to that of the Parent Index. The Underlying Index is also constrained in its construction to limit turnover and has a capping methodology applied to issuer weights so that no single issuer of a component exceeds 25% of the Underlying Index.

The way to look at it is that the above average expenses of UTLF are the cost paid for employing the specific investment objectives quote above. If this objective is in sync with your wants as an investor, then this could be the ETF for you. Just realize that because of the distinct strategy, this fund is playing a slightly different sport than the others. This article is aimed at investors who are looking for the best ETF that passively covers the US utilities sector. Also, I'll mention that these types of articles of mine that focus on ETFs in a particular sector are not forecasts of which ETF will outperform all of the others. I view the expenses as a sign of efficiency of the fund, as well as a sign of their willingness to be competitive and attract more investors. The biggest names in the world of ETF providers are already competitively lowering their fees each year to bring in more money, but this doesn't mean you should put less emphasis on the fees when searching for the right fund. Fees may be getting slowly lowered across most of the industry, but there is still no reason to pay more because of superior past performance. Since I'm not predicting future performance of any of the funds I'm analyzing in these articles, low expenses and a simple, logical investment theme will be at the forefront of which ETF could be right for investors that want to pursue a particular sector or theme.

The next two funds to take off the list are IDU and JHMU. With JHMU, you pay the most expenses of any of these ETFs in exchange for another multi-factor themed index in the same manner as UTLF. I'm not comparing the specific calibrations of the indexes of JMHU and UTLF, but they both charge higher expenses for the multi-factor approach. With IDU, there is simply no reason to pay 44 basis points for a slightly different passive index than the others. This could well explain the net outflows of 27.11 million in the fund over the past year, shown in the earlier chart.

This whittles the list down to only three, XLU, VPU, and FUTY. These three clearly are the lowest cost and have many similarities. The biggest difference though is that XLU has the highest fees of the three, and the benchmark has fewer companies than that of VPU and FUTY. Of these two, the two basis points in difference does matter since the benchmark is identical for both. Both have the advantage of fee-free trading through their own specific brokerages, which is a very big deal for those who are looking to dollar-cost-average their money into these ETFs. FUTY has got to be the ideal choice then, as it provides solid exposure to the sector with only 8 basis points in fees and zero transaction costs when traded through a Fidelity brokerage account.

Conclusion

The utilities sector is not quite in lock-step with the rest of the market, as the defensive nature keeps share prices from growing like companies in other sectors can, and the emphasis on the dividend attracts certain types of investors who are investing for income rather than capital gains. The dividend yields themselves are higher in the utilities sector than the rest of the market, so a low-cost ETF can provide a simple solution to the investor looking for exposure to the sector. Of the rather limited choices out there, my top pick is Fidelity's FUTY, which has a mere 8 basis points in expenses as well as fee-free trading through the Fidelity platform. This fund offers the most effective exposure to the US utilities sector at the lowest costs.

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.

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