A Low-Cost, High-Yielding Equity Sector ETF

For investors seeking broad exposure to defensive, high-yielding United States utilities companies,

XLU's holdings include regulated utilities, diversified utilities, and unregulated power generators. Many utilities firms are known for their reliability and income generation. This ETF is suitable as a satellite holding for a diversified equity portfolio, given that the utilities sector makes up only about 3% of the S&P 500. The fund also can serve as a tactical bet on low interest rates and long-term growth in electricity demand.

Like most ETFs that invest in utilities companies, XLU pays a healthy yield. The fund's yield is currently 3.8%, and during the past few years it has averaged around 4%.

Before 2000, most investors viewed the utilities sector solely as a reliable, income-generating space, one that wasn't necessarily known for price appreciation. That all changed with the new millennium and the beginning of a long decline in interest rates that unquestionably broadened utilities companies' investor base. Over the longer term, in a rising-rate environment, investors should expect flat returns at best for utilities companies and underperformance compared with other equity sectors. Higher rates generally make fixed-income instruments more attractive on a relative basis and make bondlike equities, such as utilities companies, less attractive.

During the past 10 years, this ETF's volatility of return of 13.8% is lower than the S&P 500's standard deviation of 14.9%. This fund has been less volatile than the broader market because of the sector's generally stable cash flows and lower sensitivity to economic cycles.

Fundamental View Long viewed as bond substitutes, utilities tend to generate stable cash flows and attractive yields. There is a long-standing relationship between interest rates and utilities' performance relative to the rest of the market. When rates rise or investors fear higher rates, utilities tend to underperform. During a low-rate environment or when rates are falling, utilities tend to outperform. If rates rise, Morningstar's equity analysts project flat returns for utilities and underperformance relative to other U.S. equity sectors.

Because dividends are such a major part of the story for utilities investors, it's worth discussing the outlook for payout ratios. There is no wholesale threat to dividends across the sector. Given strong company fundamentals, Morningstar's equity analysts forecast a sector average payout of 60% for 2015--in line with historical averages (the sector's average payout for 2014 was 57%). Also, with sustainable payout ratios, they believe that dividends could grow as much as 5% annually. That's above the sector's median 3% earnings growth during the past three years.

Dynamics that utilities-sector investors should watch closely include continued low electricity demand because of improved energy efficiency of appliances and light bulbs, the impact of low natural gas prices on higher-cost coal and nuclear plants (and broadly, on unregulated power producers), and new environmental regulation, which could result in coal plant closures, reduced emissions, and increased capital investments. In the medium term, new environmental regulation could have the effect of taking plants off line, causing higher power prices and boosting diversified utilities and independent power generators during the next five to 10 years.

Consolidation continues to be a trend as utilities seek opportunities to invest capital and achieve cost synergies. Notable recent deals are

Most utilities include debt as part of their capital structure, generally borrowing to fund capital expenditures and issuing dividends from retained earnings. Regulators allow regulated utilities firms to pay dividends, borrow for capital expenditures, and then raise rates to fund debt service. Our analysts assign most regulated utilities narrow Morningstar Economic Moat Ratings, as they have reliable cash flow streams and some monopolylike characteristics but also are subject to regulators. Our analysts assign no moat to unregulated utilities, which are commodity power producers with no differentiated characteristics.

Portfolio Construction XLU tracks the Utilities Sector Select Index, investing in all 29 utilities companies in the S&P 500, and it weights these holdings in proportion to their float-adjusted market capitalization. S&P's cap-weighting approach limits individual positions to 19% of the portfolio, though XLU's largest holding falls well below that mark. Electric utilities represent 56.5% of the portfolio, but diversified utilities also have meaningful weight (almost 40%). Independent power producers and energy traders and gas utilities, respectively, account for 2% and 1.5% of the portfolio. Because of its limited number of holdings, the portfolio is highly concentrated. The top 10 holdings soak up more than 60% of the fund's assets. Additionally, its holdings only account for about 3% of the total assets in the S&P 500. XLU has consistently fallen in the deep-value zone of the Morningstar Style Box.

Fees The fund charges a reasonable 0.14% expense ratio, making it the second-lowest-cost, large and liquid utilities fund available. Both the fund and its holdings are liquid, which keeps its bid-ask spread tight and minimizes deviations from net asset value. State Street engages in share lending, the practice of lending out the fund's underlying shares in exchange for a fee. It passes about 85% of the gross proceeds to investors, which partially offsets the fund's expenses.

Alternatives

Investors looking for better-diversified exposure to the utilities sector should consider

Fidelity MSCI Utilities Index ETF FUTY is an inexpensive alternative (0.12% expense ratio). However, this fund has minimal assets and is thinly traded. FUTY tracks a slightly different index--the MSCI USA IMI Utilities Index--while VPU tracks the MSCI U.S. Investable Market Utilities 25/50 Index. The two indexes are very similar, with nearly identical weighting schemes, almost the same number of constituents, and minimal differences in their current holdings. FUTY's key differentiating feature is the fact that Fidelity customers with a minimum balance of $2,500 can buy FUTY commission-free. Customers who sell after a short-term period (30-60 days) may be subject to a trading fee levied by Fidelity; customers who own for longer periods of time are not subject to any such fee.

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