Will Rising Rates Power Down Utilities Stocks?

A version of this article was published in the October 2015 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor by visiting the website.

U.S. utilities stocks underperformed the S&P 500 in 2015. In aggregate, this defensive, high-yielding sector slid about 4.9%, which was about 615 basis points worse than the performance of the broad benchmark. And while the bondlike utilities sector's underlying fundamentals generally remain strong, the sector's underperformance stems from the long-standing relationship between the price performance of utilities firms and interest rates. 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.

Does that mean that in the current environment--with the U.S. Federal Reserve recently implementing its first interest-rate increase since 2006 and further rate increases likely--investors should shy away from utilities companies? Not necessarily. Instead, investors should closely determine their own outlook for interest rates as well as these firms' fundamentals and then act accordingly. Considering that in 2014 the sector delivered double the return of the S&P 500, there's no question that the utilities sector is now reeling. For investors who hold a contrarian view on the U.S. Federal Reserve's future actions on interest rates, a utilities-sector investment could make some sense.

For investors considering utilities firms, an exchange-traded fund is an ideal way to gain access to the sector. While it is one of the three smallest sectors of the S&P 500--it makes up a little more than 3% of the broad benchmark--there nonetheless are a large number of publicly traded U.S. utilities firms, and an ETF offers investors the opportunity to diversify across the sector and mitigate single-stock risk.

The Lay of the Land Before going further, let's define the parameters of the utilities sector. Broadly, the industry consists of regulated utilities, nonregulated utilities, and diversified utilities. By definition, regulated utilities are subject to regulation. This regulation lends itself to reliable cash flow streams and some monopolylike characteristics. As a result, narrow Morningstar Economic Moat Ratings are given to most regulated utilities. Unregulated utilities effectively are commodity power producers with no differentiated characteristics (and no economic moats), while diversified utilities are ones that receive a material amount of operating income from both regulated distribution activities and market-based energy businesses.

By type of service provided, the majority of the utilities sector consists of electric utilities. Companies offering multiple services--such as

Perhaps counterintuitively, electricity demand actually has remained low in the United States even amid the post-financial-crisis economic recovery. Although more people are driving electric cars and relying on electronic devices for everyday life, more-efficient appliances and lighting have conspired to meaningfully reduce the U.S.' energy intensity, which is calculated as energy use divided by gross domestic product. So, while electricity demand is still growing in the U.S., it is doing so at an ever-slower rate.

Despite weak electricity demand, the utilities sector's financial health remains strong. The sector's payout ratios are strong (about 60%) and sustainable, there are no imminent threats of dividend cuts, and there are good growth opportunities. In addition, gas utilities are seeing meaningful demand growth as customers switch from other heating sources to natural gas. This phenomenon is most pronounced in the Northeast, where households are switching away from fuel oil, but it also is noticeable nationwide.

The Impact of Interest Rates on the Utilities Sector 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 firms' investor base.

Today more than ever, with interest rates near zero, the utilities sector has served as a bond substitute. In aggregate, the companies in large utilities ETFs currently yield between 3.6% and 3.9%.

Rising interest rates are generally bad for utilities firms, as yield investors often sell to rotate into more-attractive fixed-income securities, which then depresses valuation multiples in the utilities sector. In addition, higher rates mean that utilities firms are stuck borrowing at higher rates to fund growth, which leads to higher interest expense, thus putting pressure on earnings.

However, even in a rising-rate environment, the picture is not abysmal for utilities firms. Morningstar's equity analysts have concluded that 10-year U.S. Treasury rate changes over periods of two-plus years have had virtually no impact on utilities firms' total returns. While firms' returns relative to the S&P 500 were terrible during periods of rising rates, absolute returns were actually better when rates were rising the fastest than when rates were falling the fastest during those periods of two-plus years, likely because rising-rate periods tend to coincide with an improving economy.

Market-Cap-Weighted Utilities ETFs There are three large ETFs focused on the U.S. utilities sector. All three funds closely track market-cap-weighted indexes. This means that the largest utilities firms hold the most sway. Given the fairly homogenous nature of the sector and the fact that all three funds track cap-weighted bogies, it should come as little surprise that all three ETFs have produced very similar performance.

By far the largest and most liquid utilities ETF is

An even cheaper option is the broader

Investors should avoid the third-largest utilities ETF,

Another market-cap-weighted utilities ETF to consider is the very low-cost Fidelity MSCI Utilities ETF FUTY, which charges just 0.12%. 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.

Strategic-Beta Utilities ETFs There are several options for investors seeking strategic-beta ETFs covering the utilities sector. All have relatively minimal amounts of assets, however, and none are covered by Morningstar. First Trust Utilities AlphaDEX ETF FXU tracks a proprietary multifactor benchmark. The fund holds 40 stocks and charges an annual fee of 0.70%. The fund's benchmark uses value and momentum (First Trust calls it "growth," but it is really momentum) factors to select stocks. Meanwhile, Guggenheim S&P 500 Equal Weight Utilities ETF RYU charges 0.40% and equally weights its portfolio, which consists of all utilities companies found in the S&P 500. Finally, PowerShares DWA Utilities Momentum ETF PUI, which holds 40 firms and costs 0.60%, tracks an index of utilities firms that have been showing relative strength, or momentum.

Strategic-beta utilities ETFs have had a mixed score card relative to cap-weighted funds. RYU has outperformed cap-weighted utilities ETFs over the past one-, three-, and five-year periods. However, FXU's performance has lagged cap-weighted peers in trailing one-, three-, and five-year periods. It is harder to judge PUI's performance; the ETF was recast in February 2014 to track a Dorsey Wright-managed index based on momentum. However, its early performance has been middling.

Sector Valuation One final note that investors should keep in mind is that, even with the recent pullback, the utilities sector remains well-valued relative to other U.S. equity sectors. Morningstar's fair value estimate for ETFs is a helpful way to quickly give investors an aggregate, asset-weighted fair value estimate of the stocks covered by Morningstar in an ETF's portfolio.

According to Morningstar's equity analysts, XLU, VPU, and IDU were all trading at 98% of their fair value as of Jan. 8, 2015. While 98% of fair value may sound reasonable, it is actually rather richly valued in light of U.S. stocks' recent pullback. Indeed, the S&P 500 is currently trading around 88% of its fair value, and the utilities sector is the single most richly valued U.S. equity sector. In contrast, the strategic-beta ETFs' price/fair value measures are a bit more dispersed; as of Jan. 8, FXU was trading at 91% of fair value, RYU at 94% of fair value, and PUI was changing hands near 102% of our analysts' assessment of its fair value.

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