How to invest in utilities

Adding utility stocks can provide income and reduce volatility in a portfolio.

  • By Ellen Chang,
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Utility stocks are viewed as a safe investment to add to a portfolio since these companies are part of a regulated industry and often have fewer competitors.

Since utility companies are regulated entities, the cash flow and profits of the businesses are highly predictable, allowing them to pay very consistent dividends, says Derek Horstmeyer, an associate finance professor at George Mason University in Fairfax, Virginia.

"Utility companies make a nice addition to any portfolio as a risk reduction tool entirely because of the environment which they operate in," he says. "This means they are low volatility additions to anyone's portfolio and they can really add value to a portfolio when facing downside risk because of the steady income they provide."

What are utility stocks?

The utilities sector covers the energy value chain, which goes from the generation of power to the electric plug in the consumer's home, including transmission and distribution networks.

Beyond electricity, the sector includes natural gas distribution as well as water and waste services, says Jean-Hugues de Lamaze, managing director and senior portfolio manager at Tortoise Advisors.

"These are essential asset-backed services," he says. "Alternative ways to produce electricity via renewable energy sources, mostly wind and solar, have become growing components of the utilities investment space over the past decade."

Utilities are more correlated with bonds than stocks and most investors need protection from downside stock-price risk, says Charles Self, chief investment officer at iSectors, an investment manager in Appleton, Wisconsin.

"If they don't have it, they may sell out of stocks at low prices and not buy back until they are much higher in price," he says. "Utilities serve as a buffer in many equity portfolios so that portfolio values don't go down too much in a market correction or bear market. This keeps investors in the stock market for the long run."

The advantages of adding utility stocks

Since utilities stocks represent resources that are needed regardless of how the economy is performing, they are known as defensive plays for an investor's portfolio, says Mike Loewengart, chief investment officer at E-Trade Financial, an Arlington, Virginia-based brokerage company.

One alarming trend is that many utility companies are facing new and extreme challenges as weather trends shift and they are "on the hook for huge repairs from fires, floods and other natural disasters," he says.

Utilities tend to be good investments in low interest-rate environments because they typically provide a consistent dividend.

"They are not without risk and can be more volatile than bonds as utilities are still subject to the systematic movements of the equity markets," Loewengart says.

Utilities are considered recession resilient because of the constant demand from customers, resulting in a regular and predictable cashflow, says Chris Osmond, chief investment officer at Prime Capital Investment Advisors in Overland Park, Kansas.

Since the future cash flow of utilities tends to be predictable, the sector typically has a weak correlation to global equity indexes, de Lamaze says. This sector tends to be favored by income investors looking at stable and growing dividend income.

"Understanding the regulatory framework is a key element to consider before investing in utilities since regulators are responsible for setting allowed returns as well as the general framework around investments and cost recovery," he says.

The disadvantage of utility stocks

Since water, power and sewage companies are often regulated by local and state governments, companies can't raise rates very often or quickly. Being heavily regulated can be a double-edged sword, says Viraj Desai, senior manager of portfolio construction at TD Ameritrade.

Regulations can increase the cost of doing business for a utility and lower its earnings potential, but regulations also provide utilities with "certain monopolistic characteristics by providing them exclusivity in certain regions and reducing the threat of competition," he says.

Adding utility stock exposure can complement a balanced portfolio since utilities can provide diversification when cyclical stocks are underperforming, Desai says. More conservative investors who have bonds or other fixed-income securities in their portfolio could add utilities since the sector offers income.

How to add utility stocks to a portfolio

Utilities are defensive investments and in uncertain environments, investors may flock to defensive sectors like utilities and consumer staples, Osmond says.

During a bull market when the economy is growing at a strong pace and interest rates rise, the sector typically underperforms.

"As interest rates on bonds rise, investors typically are no longer receiving adequate compensation for maintaining their allocation to riskier high yielding assets, like utilities stocks, so they typically transition back to less risky investment-grade bonds paying an equivalent or higher yield," he says.

Investors should look for consistency of dividend payouts and funds with low expense ratios, such as the Vanguard Utilities ETF (VPU), Loewengart says.

"The benefit of investing in a utilities ETF is the diversified exposure to the sector, so be sure to check out how closely the fund tracks to the benchmark," he says.

When a utility portfolio has sufficient diversification, it can lessen the impact of occasional dividend reductions and eliminations made by utilities that get into cash flow trouble, says Christopher Muir of CFRA, a New York financial research company.

In 2017, PG&E Corp. (PCG) eliminated its dividend when the company's liabilities rose due to wildfires caused by its equipment and California's regulatory rule, he says.

Mutual funds and exchange-traded funds such as Utilities Select Sector SPDR ETF (XLU) and IShares U.S. Utilities ETF (IDU) provide diversification and less risk for investors.

One of the cheapest and most highly liquid funds that invests solely in S&P 500 utility companies is the Utilities Select Sector SPDR ETF. This ETF leads its segment with vast assets and volume, while concentrated in a number of large firms, Osmond says.

"With recession fears looming and the latest concerns involving U.S.-Iran tensions, investors tend to seek out safe havens and/or recession-resilient investments like XLU," he says.

When seeking more diversified exposure to the U.S. utilities sector, the IShares U.S. Utilities ETF also includes large-cap utility companies. The ETF provides exposure to both mid-cap and small-cap utilities that attempts to mirror the Dow Jones U.S. Utilities Index, which includes the top 95% of U.S. stocks constructed around float-adjusted market capitalization.

Electric utility companies account for approximately 53% of the fund, followed by multi-utilities and natural gas companies. Because the ETF's underlying index is weighted according to market cap, its top 10 holdings are all large-cap companies, which includes Duke Energy Corp. (DUK) and NextEra Energy (NEE).

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