Why It May Be Time To Play Utility Sector ETFs For The Long-Haul

Eric Dutram: Although investors now have a firmer grip on the political picture, and with China and Europe seemingly staving off a crisis for now, many thought that gains would be easy to come by heading into the final part of the year. Unfortunately, this has not been the case as new worries over the economy jumping down the Fiscal Cliff have weighed on stocks in November.

During the period immediately following the election, equities were down across the board as threats of tax hikes and spending cuts pushed many to cash out of their positions. Nowhere was this more true than in the dividend space, as these, along with high flyers across the board, took the brunt of the selling pressure.

This outsized selling isn’t exactly unwarranted either, as dividend taxes could nearly triple starting in 2013 if nothing is done to change the terms of the fiscal cliff. Obviously if dividend taxes end up being closer to 45% than their current level at 15%, this will drastically change the investment case for several sectors of the market.

Arguably one that will be the most impacted is utilities. This space isn’t exactly known for its growth, but thanks to its low competition and high barriers to entry, has been a stable play that has become famous for its outsized yields.

Given this reality, much of the investment case for the sector has been predicated on dividends and lots of them. Now with the prospect of after-tax yields pretty much being cut in half, some are clearly starting to reconsider investing in the space (see Three Excellent Dividend ETFs for Safety and Income).

This has resulted in a huge sell-off in utility ETFs in the weeks following the election and the shift towards worries over the fiscal cliff. In fact, over the past one month period, the utilities S&P 500 segment has easily been the worst performer, down 10 times more than the second worst performer and roughly a 600 basis point underperformance when compared with the broad S&P 500 benchmark.

This sell-off is probably a little overdone at this point, even if tax rates do go up significantly for both dividends and capital gains. Utilities are among the most stable sectors over long time periods and the companies in this space are likely to be decent investments no matter what the overall federal fiscal policy is at the current juncture.

For these reasons, investors may want to consider now as an opportune time to play the utility sector for the long-haul. The space has—arguably—been unfairly beaten down in the recent sell-off and could be due for a nice bounce once investors get some clarity on fiscal issues heading into 2013.

If investors are interested in this thesis, we have briefly highlighted below a few of the biggest utility ETFs on the market, any of which could make for intriguing picks for long-term oriented value investors at this time:

Utilities Select Sector SPDR Fund (NYSEARCA:XLU)

This is the most popular utility ETF targeting the American market, charging investors 18 basis points a year in fees. The product is a pretty high yielder, with dividends, in 30-Day SEC terms, coming in just under 4% (read 11 Great Dividend ETFs).

The ETF holds about three dozen securities in its basket, with top weights going towards Duke Energy (NYSE:DUK), Southern Co. (NYSE:SO), and Dominion Resources (NYSE:D). This gives XLU a heavy focus on electric utilities, although multi-utilities account for about 36% of assets as well.

Over the past month, XLU has lost about 7.9%, while the product currently has a Zacks ETF Rank of 3 or hold and a medium Risk Rating.

iShares Dow Jones US Utilities Sector Index Fund (NYSEARCA:IDU)

This fund tracks the Dow Jones U.S. Utilities Index, charging investors 47 basis points a year in fees for this service. Dividends come in a little lighter for this ETF, as the product has a 30-Day SEC payout of 3.2%.

The product does hold over 60 stocks in its basket though, so it could offer a more complete look at the sector across market cap levels. Still, the same three companies that sit atop XLU occupy the top three spots of IDU (read the Guide to Utility ETF Investing).

Over the past one month period, IDU has lost about 7.3%, showcasing another weak performance for the space. Currently, this ETF does have a Zacks ETF Rank of 1 or Strong Buy, while it also has a Medium Risk Rating.

Vanguard Utilities ETF (NYSEARCA:VPU)

Vanguard’s entrant in the space charges investors 19 basis points a year in fees while tracking the MSCI US Investable Market Utilities 25/50 Index. This approach looks to target all utility stocks, regardless of market cap levels, that are trading in the U.S., giving the product a 30-Day SEC yield of roughly 3.9%.

VPU does hold the most securities in its basket at just under 80, while it too puts a majority of its assets into the electric utilities segment. There is a slight shakeup at the top holdings, as Exelon replaces Dominion in the number three spot, with Dominion sliding down to number four in this ETF.

This fund is down about 7.4% in the last one month time frame, putting it in the middle of the three funds on the list. Currently, this ETF does have a Zacks ETF Rank of 1 or Strong Buy, while it also has a Medium Risk Rating.

Written By Eric Dutram From Zacks Investment Research   

In 1978, Len Zacks discovered the power of earnings estimates revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank, a peerless stock rating system whose Strong Buy recommendation has an average return of 26% per year.

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