Once Safe Havens, Utility Funds Rethink Themselves

Dec. 23, 2002 -- Consider it official: these are not your father's utility funds.

Once, utility funds were regarded as the safe havens of the mutual fund world: great investments for widows and orphans, and a perfect way for a nervous neophyte to dip his toe into stock investing. However, thanks to deregulation, those days are gone. Through the first eleven months of 2002, utility funds as a group sank 23.4%, lagging most kinds of growth funds, with the exception of the extremely volatile technology and telecom sectors, according to Standard & Poor's. The Dow Jones Utilities Average is now hovering near its lowest level in 14 years.

That trend prompted Vanguard Group to request and obtain shareholder approval for renaming and redefining the mandate of Vanguard Utilities Income Fund (VGSUX). Going forward, the fund will be transformed into Vanguard Dividend Growth Fund, which may invest in utilities, but will be free to seek out stable income wherever it can be found. The goal, Vanguard officials say, is to avoid confusion among investors over the nature of the fund.

"The original intent behind the utilities fund was to offer a high level of current income, and reliable income," says Joe Vernon, senior investment analyst at Vanguard's Portfolio Review division. "For the most part, utility stocks were highly-regulated, stable entities characterized by lower volatility and strong cash flow. And investors still think of them that way."

Instead, by the late 1990s, Vanguard's fund -- like many other utility funds -- was full of companies that fell far short of providing those characteristics, although they still qualified as utility stocks. Deregulation in both the power industry and in telecommunications meant that utilities faced a more competitive environment, and a host of new entrants. Power generation and power distribution businesses were separated by bankers; with power generation companies rapidly accelerating their spending, said one investment banker who helped raise capital for the sector. The spending was even more dramatic among telecom service companies, where the proliferating number of competitors raised capital and spent at a dizzying rate in order to gain market share. The consequences weren't surprising: by 2001, both industries were facing serious overcapacity and a crunch on profitability.

"You had a tremendous number of factors creating a much more volatile market and business environment for companies that were only just getting used to being deregulated," says Judy Sarayan, manager of Eaton Vance Utilities Fund (EVTMX). "All of a sudden, they're having to grapple with the impact of sudden exposure to free markets and volatile pricing."

Investors' conceptions about the nature of utility companies doesn't match the changing realities that the industry finds itself in.

Two years ago, the Colonial Funds complex (which are now part of Columbia Management Co), polled its stockholders and discovered that the majority considered utility funds as a safe, low-risk investment, said Scott Schermerhorn, a portfolio manager at Columbia. "We've been studying what to do with the fund as a result of that," he says. "Deregulation transformed the nature of the utilities business and raised the component of risk." As such, both investors and financial advisors need to educate themselves about the swift changes that have impacted the utility industry.

The key, financial advisors agree, is to look beyond the label on the fund and scrutinize the kinds of stocks it includes. From that, it's possible to determine whether the manager is attempting to stay true to the spirit of utility funds of old by selecting those utilities that offer the best possible combination of low volatility and high income. It's also possible to winnow out those funds whose managers are taking a more aggressive approach by investing in the more volatile energy-trading concerns or new telecom players.

For instance, an investment in WorldCom, which filed for bankruptcy court protection after disclosing billions of dollars in accounting irregularities, would have qualified as a utility company, according to the guidelines of most utility funds.

Today, companies like Duke Energy (DUK), accused by regulators of engaging in deceptive accounting practices, remain eligible for inclusion in a utility fund, managers note. So, too, does El Paso Corp. (EP), the country's largest pipeline company, which expects to take a fourth-quarter charge of between $400-million and $600-million against its earnings thanks to an ill-fated foray into energy trading. The list of other power companies facing a variety of problems is a long one.

Still, not all managers are rushing to abandon the traditional utilities. Sarayan argues that it's still possible to run a utility fund with a traditional conservative slant, and that investors and their advisors should be able to pick out these funds from the rest by closely examining their holdings, their trading patterns and their track record.

"We invest in the regional Bell companies and rural phone companies because they have the best recurrent revenues, and so they fit our definition of utilities," says Sarayan. "They have good balance sheets and the potential to increase dividends. These companies may be a lot more scarce than they used to be, but they're out there."

The current troubles in the electric utility industry may lead to consolidation, Sarayan believes, which, in turn, will lower costs and improve efficiency and therefore profitability for the sector.

Eaton Vance recognizes it needs to communicate better with investors, Sarayan adds. "Our message is that this is still an acceptable fund for a conservative investor, even though it may take us a lot more legwork to find companies like those they knew and loved."

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