The first half of 2015 was a disappointment for exchange-traded funds that track utility stocks. These ETFs were broadly sold as investors banked profits from solid performance in 2014 and worried about the implications a rising rate environment. The threat of a Federal Reserve rate hike coupled with an overshoot to the upside in intermediate-term U.S. Treasury bond yields created a headwind for this defensive sector.
The Utility Select Sector SPDR (XLU) is the largest ETF in this space, which tracks 31 large-cap publicly traded utility stocks. XLU has over $7.1 billion in total assets and charges an expense ratio of 0.15%. In addition, this fund sports one of the highest dividend rates of the major S&P sectors with a 30-day SEC yield of 3.49%.
Top holdings in XLU include well-known names such as Duke Energy Corp (DUK), NextEra Energy Inc (NEE), and Dominion Resources Inc (D). Together, these three names make up 25% of this market cap weighted index.
Through the first six months of the year, XLU dropped 10.70% as the 10-Year Treasury Note Yield experience a sharp rise. Utility stocks typically experience an inverse correlation to interest rates (similar to Treasury bonds). This sector is widely considered to be a defensive standout during periods of weakness in high beta areas of the market.
As you can see on the chart above, after bottoming in June, XLU has risen nearly 10% as this index seeks to return to the flat line for the year. The sharp drop and subsequent rebound is uncharacteristic of a historically low volatility sector, yet speaks to the divergence in stock momentum this year. XLU is now back above its short and long-term moving averages, which is also a sign of strength for technical enthusiasts.
Not coincidentally, this rally has occurred on at a similar inflection point for interest rates. The flight to quality in Treasury bonds has created a tandem effect in utility stocks that is illustrated on the overlay chart below. The inverse correlation between these two forces is an easily recognizable pattern in this instance.
According to data from ETF.com, XLU has experienced very little in net dollars added or subtracted since the beginning of the year through August 17. The tug of war between buyers and sellers has essentially been a draw. However, signs of activity have begun to materialize with the short-term strength in August. Last week, XLU was the number one ETF in net inflows, with $565 million in new money added.
This data may indicate that investors are starting to take notice of the new uptrend and looking to add equities to their portfolio at more attractive relative valuations than high flying internet, consumer discretionary, and health care stocks.
The dividend yield on utilities is another reason many investors like to own these companies. The utility sector currently makes up 33% of the asset allocation in the iShares Select Dividend ETF (DVY). This ETF tracks 100 stocks with histories of high dividend payouts and has a current 30-day SEC yield of 3.36%. The overweight nature of the utility exposure in this index weighed on returns in the first half of the year, yet are helping to boost short-term performance in July and August.
The Bottom Line
While the strength in this sector is a sign of improvement for broad-based participation in the stock market, it is also a wary indicator of uncertainty as well. This new leg higher has the potential to be interrupted by monetary policy changes implemented by the Federal Reserve, a broad-based sell off in stocks, or a sentiment shift in the bond market.
Keep in mind that tracking the progress of the utility sector can help reveal strengths and weaknesses in other areas of your portfolio and/or the general market as well.