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Our Pick in Utilities ETFs

Jeremy Glaser

Jeremy Glaser: I'm Jeremy Glaser with Morningstar.com.

PIMCO's Bill Gross recently wrote that as more industries get regulated by the government and act like utilities, investors might just want to buy utilities themselves instead of dealing with the zero percent interest rate that they've been getting on money market funds.

Here to discuss this with me is ETF strategist Paul Justice. Paul, thanks for joining me.

Paul Justice: A pleasure to be here.

Glaser: So do you agree with Bill that it makes sense for investors to be looking at utility stocks right now?

Justice: Yes, I think Bill made a cynical point when he was saying "as industries get more regulated," but I think there are other great reasons to buy utilities that he also pointed out.

It's true with a money market fund, you're getting a near-zero yield, and it's going to take you centuries to double your money if you're in these funds. And while that might be good for capital preservation, it's not very good for real returns over the life of a normal human being.

I think that he points out an interesting statistic. The dividend yield of utilities is very high right now, not only relative to other sectors but also in a historical context and when you're comparing it to corporate bonds or something like that.

So we've been looking at utilities in our ETF Investor newsletter, and we find it to be a very compelling investment just from a value perspective.

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Glaser: Which are the options that people have for buying utilities in an ETF?

Justice: Well, we elected to really look at the SPDR utility fund. It's a sector fund. The ticker is XLU. The reason why we like that fund is it gives us the coverage that we want at the lowest fee that's available on the market, and it also has sufficient liquidity.

There are two competing offerings that are also very nice funds as well that have more diversification in them, particularly the Vanguard Utilities sector fund. But what we didn't like about that was a very slightly higher fee. It's only about two basis points more expensive, but it doesn't have the liquidity of the SPDR fund.

IShares also has a competing product that offers more diversification, but the fee is substantially higher at 48 basis points. That might be small compared to mutual funds, but in the ETF sector landscape, it makes it a little bit more expensive than what you can find elsewhere.

Glaser: When looking at utility stocks, one of the things that people are talking a lot about are cap and trade, and potentially pricing carbon. Do you think that those kinds of initiatives that are working their way through Washington right now could have a serious effect on the price of these ETFs?

Justice: Eventually they could. I would say that those factors have been priced into utilities now for well over five years. These aren't new subjects that have come up. That's a risk that's really played in, and I think has been exhibited by the equities.

What I do like about utilities right now is you're getting a good yield, and you're also not seeing the capital expenditures come out of utilities like you saw in the previous five years. A lot of budgets have been scaled back, and there's now excess generation capacity compared to where we were just a couple of years ago.

That means as industrial demand picks up and more generation is fired, that's going to be cash filling the bottom lines of these utilities. They've got those idle plants. They just turn them on.

So I think that's going to be a good catalyst for them over the next couple of years.

Glaser: Do you see any other potential downsides that could hit utilities coming forward, or do you really see it as it's going to be a pretty steady revenue stream coming to investors in the foreseeable future?

Justice: Well, on the regulated side, I think it's going to be the stable return that you would come to expect. On the merchant side, it gets a bit more tricky. It's going to be levered to natural gas prices, and gas prices have been very volatile recently.

I would say that there's more upside potential for merchant generators right now than downside given the total falloff of industrial demand for electricity. I would think that would pick up.

Longer term I would say alternative energy sources that could eat into that pie might play a factor, but I don't think that they're going to be substantially outpaced, just overall electricity growth.

So if you see solar and wind really pick up, longer term that could be a factor, but I don't think it's going to be any kind of apocalypse for any of these players.

Glaser: So for investors who agree with Bill Gross, there seem to be a couple good ETF options for investing in the utility space.

Thanks so much for joining me.

Justice: My pleasure.

Glaser: For Morningstar.com, I'm Jeremy Glaser.