Ahead Of The Fed, Investors Ditch Utilities ETFs

One way or the other, the Federal Reserve will be making a decision on interest rates on Thursday. Either benchmark U.S. interest rates are going to continue hovering near or zero or, as some market participants expect, those rates will rise by 25 basis points.

Examining recent flows data for select rate-sensitive exchange traded funds is a task unlikely to give investors a clear idea regarding what the Fed is going to decide. For example, the high-yields and bond-like properties of preferred stocks would seemingly make that asset class vulnerable to higher interest rates, but investors have recently been pouring money into the iShares U.S. Preferred Stock ETF (NYSE:PFF) and the PowerShares Preferred Portfolio (NYSE:PGX), amongother preferred ETFs.

Conversely, investors have been far less sanguine about utilities ETFs. In fact, they have been downright skittish as highlighted by the $549.3 million in month-to-date departures from the Utilities Select Sector SPDR (NYSE:XLU), the largest utilities ETF.

Why This Makes Sense

Investors' angst as it pertains to the utilities ahead of potentially hawkish moves by the Fed makes sense. In the case of XLU, it is the most negatively correlated to interest rates of the nine sector SPDR ETFs. History confirms the laggard status of utilities stocks following interest rate increases.

"Telecom was the worst or second worst performing sector in terms of average cumulative returns in 6 out of the 12 months following Fed liftoff, said Bank of America in anote out last week. The bank added utilities were lackluster throughout the 12 months after Fed liftoff.

Investors' September disdain for utilities ETFs has not been limited to XLU. The Vanguard Utilities ETF (NYSE:VPU) and the iShares U.S. Utilities ETF (NYSE:IDU) have lost $30 million combined this month.

Some traders are even outright betting against utilities ETFs. Short interest in XLU was recently as high as 36 percent of shares outstanding, according to AltaVista Research, thethird-highest total among the nine SPDRs.

Interestingly, utilities stocks are inexpensive relative to the S&P 500, a rarity for the ultra-defensive sector that usually forces investors to pay-up for the luxury of that defensive posture. XLU's estimated 2015 price-to-earnings ratio is 15.5 compared to 16.7 for the S&P 500, according to AltaVista.

Environmental regulations and distributed generation represent dual threats to profitability-- witness the declining trend in Return on Equity and margins over the past few years, which may appear small but are forecast to result in less than 1% earnings growth between 2010-15E. That said, the P/E ratio has come off its highs from earlier this year, so the sector could get another look from value and income value investors, especially if the Fed delays raising, said AltaVista of XLU.

The research firm has a Neutral rating on XLU.