Utility ETFs In Danger of Short Circuiting

By Tom LydonETFsFOXBusiness

The utilities sector remains the best performing area of the S&P 500. However, a rising rate environment could cause utilities to underperform. While investors may have enjoyed the ride by overweighting the sector, exchange traded fund investors should also take the time to look under the hood of some of their investment plays lest they end up with a nasty surprise when rates do rise.

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The Utilities Select Sector SPDR (NYSE:XLU) has gained 17.0% year-to-date, outpacing the 4.7% return in the broader S&P 500 Index.

Investors view utilities as a reliable, income-generating asset that exhibit bond-esque characteristics, which has helped the sector outperform as market volatility spiked and bond yields remained low this year.

The outperformance in utilities has also caused the sector to expose investors to some frothy valuations. According to the Goldman Sachs Group, utility stocks are trading at rich levels after investors took refuge in the defensive sector. Regulated utilities now trade at a forward price-to-earnings ratio in excess of the S&P 500 based on estimated 2017 and 2018 earnings. Moreover, the P/E ratio is also high relative to the sector's five-year average.

Now, the fortunes of the utilities sector seem to be tied to the Federal Reserve's interest rate outlook. Once the Fed eventually hikes interest rates, the higher rates will make fixed-income instruments more attractive on a relative basis, and bond-like equities, like utilities, less enticing. Consequently, utilities may remain flat or underperform other segments of the equities market once rates start ticking higher.

The Fed, though, may push off on an interest rate hike to July, especially after the unexpectedly weak jobs data. Nevertheless, investors should begin to consider the end game and the potential negative effects a rising rate environment can have on rate-sensitive equities like utilities.

The World of ETFs...

For ETF investment portfolios, the risks extend to more than just a sector-specific bet on utilities. Since most investors take on broad ETF plays to gain diversified exposure to the markets, it is important to look under the hood and note specific sector exposures.

For example, the low- or minimum-volatility strategy has been a popular smart-beta ETF play this year as investors take a more tempered view on the markets in light of the recent wide oscillations in the equities market - the iShares MSCI USA Minimum Volatility ETF (NYSE:USMV), which selects stocks based on variances and correlations along with other risk factors, has attracted almost $5.5 billion in net inflows and the competing PowerShares S&P 500 Low Volatility Portfolio (NYSE:SPLV), which tracks the 100 least volatile stocks on the S&P 500, brought in $1.1 billion, according to ETF.com.

ETF investors should keep in mind that due to their indexing methodologies, the low-volatility ETFs can include heavy tilts toward traditionally conservative utilities sector. Utilities make up 8.6% of USMV's underlying portfolio and 21.2% of SPLV. In contrast, the S&P 500 allocates a little over 3% toward utilities.

Moreover, given the utilities' dividend association, the sector is also found in many dividend-focused ETF strategies. For instance, the iShares Select Dividend ETF (NYSE:DVY) is the second largest dividend-related ETF on the market, with $15.2 billion in assets under management, and the ETF includes a hefty 31.7% tilt toward utilities.

Even if one divests from utilities sector-specific plays, an investor should keep in mind that broad ETFs may still hold some exposure to utilities.

This article was provided by our partners at etftrends.com.

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