From the June 2010 issue of Investment Advisor • Subscribe!

June 1, 2010

The ETF Advisor: Utility ETFs Promise Low Volatility and Steady Dividends

In the aftermath of the stock market's two most gut wrenching years since the Great Depression, it's no secret that investors want stability and current income. For some, that means utility stocks, which typically pay outsized dividends and are historically one of the less volatile sectors of the equity market.

While Standard & Poor's Equity Research expects only "modest" gains from utility stocks in 2010, their collective dividend yield has risen year to date to about 4.7%, and several utilities are expected to raise their dividends this year. Within the utility sector, S&P Equity Research has a "positive" outlook for independent power producers, and a "neutral" outlook for the electric, natural gas, and multi-utility industries.

Independent power producers are cutting their debt levels through sales of assets and new shares, says S&P Equity Research analyst Christopher Muir. As economic growth recovers, the amount of spare generating capacity available to meet peak demand will decline, forcing prices higher.

There are currently about a dozen exchange traded funds (ETFs) targeting the utility industry both in the United States and internationally, and another dozen investing in specialty areas, such as nuclear energy, as well as more diversified infrastructure funds that devote large portions of their portfolio to utilities.

We chose three funds based on their S&P ranking, historical performance, and portfolio holdings.

For its combination of relatively high current yield, low cost, overweight ranking, and large size, the consensus choice is Utilities Select Sector SPDR ETF (XLU Overweight). With $3.2 billion in assets, it is three times the size of the second largest of the group. Its current yield of about 4.15%--paid quarterly--is at the high end of the group, as is its one-year return of 20.5%. The fund has the same top three holdings, Exelon (EXC ****), Southern Co. (SO ***), and Dominion Resources (D ***), as several other funds in the group.

A much different take on utilities is available from the First Trust Utilities AlphaDEX Fund (FXU Marketweight). The fund tracks the StrataQuant Utilities Index, an "enhanced" index since it is reconstituted quarterly. It is the only utility fund that has independent energy producers such as NRG Energy (NRG ****) and Mirant (MIR ****) in its top 10 holdings, and one of the few funds that own telecom stocks. While the fund may be small at just $33 million in assets, it has grown steadily since it opened in May, 2007 and has doubled in size since December 2008. It pays dividends semi-annually, a drawback for some, and its 30-day SEC yield is low at 2.96%. It has the best one year performance of any straight utility fund as of early May with a return of 27.6%.

Nuclear power proponents might look at the iShares S&P Global Nuclear Energy Index Fund (NUCL Overweight), one of three funds targeting nuclear power-related stocks. It owns companies involved in uranium mining, reactor design, and construction, as well as a mostly European group of nuclear operators. In doing so, it manages to steer clear of some of the large Japanese conglomerates such as Toshiba and Hitachi that are important to the nuclear power industry, but for whom nuclear power is a relatively small business.

[Note: The fund rankings in this article--from five star (best) to one star (worst)--are quantitatively derived from performance, holdings, risk, and expense analysis. The stock rankings, or STARS, using a scale of 5-STARS (strong buy) to 1-STARS (strong sell), are based on S&P equity analysts' qualitative and fundamentally driven outlook for the stock over the next 12 months.]


S&P Senior Financial Writer Vaughan Scully can be reached at vaughan_scully@standardandpoors.com. Send him your ideas for ETF story topics.
Reprints Discuss this story
This is where the comments go.