Playing Portfolio Defense: In the market for a utility player?
Recent market volatility underscores the tremendous degree of uncertainty shrouding the economic outlook. The strength of the 2009 rebound in equity, fixed income, and commodities markets would seem to suggest a "V"-shaped recovery. But bloated sovereign balance sheets, stubbornly high unemployment, and signs that China is reining in liquidity have left market participants pausing to ponder the shape of things to come. Many are now left wondering if the financial markets may be a few steps ahead of the underlying economic fundamentals. Given that the backdrop is pocked with question marks, many investors are seeking ways to build downside protection into their portfolios.
Defensive strategies can take a number of forms, ranging from liquidating your investment portfolio and shoving the proceeds under a mattress (a practice that seemed prevalent in the autumn of 2008 and early 2009) to piling into gold (also a popular trade as of late). But there are other, less drastic, ways to navigate uncertainty and mitigate downside risk in your portfolio. One approach that we suggest is investing in one of the steadiest industries around through a sector-specific ETF.
In fact, this has already proven a popular strategy amongst ETF investors during the first part of 2010. According to recent STOXX 600 Sector ETF Net Flows data from Blackrock, sector ETFs following the STOXX 600 Utilities index have experienced the second-largest new inflows on a year-to-date basis. What's driving investor interest in this sleepy sector? Let's take a closer look at the industry and the indices and ETFs that track it for some answers. We'll explore whether they might play a role in taking a defensive stance in your equity allocation and which ETFs are at your disposal.
Utilities: Low Volatility, Steady Income
Odds are that if you are reading this, you are still paying your electricity bill, and the companies responsible for generating your power and bringing it to your home are still earning respectable rates of return for their efforts. Many of these same companies are also paying out fairly steady dividends to their shareholders in spite of the current weakness in the economy. The relative acyclicality and steady dividend payments offered by utilities have long made them a favourite of risk-averse, income-oriented investors. Given the sketchy economic backdrop, and the prevailing low interest rate environment, the utilities sector may be an attractive place to park a portion of your equity allocation.
The STOXX 600 Utilities index was the worst performing of all of the STOXX sector indices in 2009, posting a meagre 0.98% return versus a 27.9% gain for the broader STOXX 600 index. This is perhaps partly due to the outperformance of the sector relative to the other 19 STOXX super sectors in what was a brutal 2008, when the broad STOXX 600 index plummeted 45.6%. In a gut-wrenching year, the utilities sector lost a relatively modest 38% of its value. Only the chemicals (-37.9%), food & beverage (-29.6%), healthcare (-17.8%), and telecommunications (-36.5%) sectors fared better in 2008. Lower volatility is part of the appeal of owning this sector during a period of market uncertainty.
Regular dividend income is another one of the more appealing features of investing in the utilities sector. For example, German utility giant E.ON AG, the largest component of the two utilities sector indices presently tracked by the largest sector ETFs--the aforementioned STOXX 600 utilities index (E.ON has about an 18% weighting here) and the MSCI Europe Utilities Index (a weighting of about 17%), presently has a dividend yield (calculated by dividing trailing dividends by the current share price) of more than 5%. The firm has also increased per share dividends by an average of 18% per year since 2004, according to Morningstar's senior utilities analyst, Travis Miller. While the current dividend yield on the sector tracking ETFs isn't quite as high--at just over 4.5%--it is still quite attractive, and better than yields on most 10-year government obligations. With the potential for future dividend increases--which could serve to offset the potential ill-effects of inflation on the purchasing power of future dividends--it is no wonder that many (including ourselves and Morningstar's pick for US fixed income manager of the decade, PIMCO's Bill Gross) have been looking favourably upon this sector as of late.
Sorting them out
So which index and associated ETF do we think are the best of breed in the utilities space? As for the relevant indices, there are currently two that are tracked by ETFs: the STOXX 600 Utilities Index and the MSCI Europe Utilities Index. Morningstar's equity analysts currently provide coverage of about 85% of the STOXX index (as measured by component weightings) and 83% of the MSCI index. Using our analysts' fair value estimates for the indices' components, we are able to gauge the fundamental value of the index (and hence the relevant ETFs). In doing so, we found that the STOXX and the MSCI indices both look to be just slightly undervalued at present, with identical price to fair value ratios of about 0.97.
Given that the current valuation of the two indices is virtually identical and their composition is very similar, we'll next look at assets under management and liquidity data for the ETFs tracking these indices to gauge which is tracked by funds that are larger, more liquid, and thus presumably have lower total costs of ownership. As it turns out, there are more than six times as many assets in ETFs tracking the STOXX 600 Utilities Index as there are in those following the MSCI Utilities Index. To gauge these funds' liquidity we took a look at NYSE Euronext data for the relevant ETFs traded in Paris. This data shows far superior liquidity amongst the ETFs following the STOXX index. For instance, the Lyxor ETF STOXX 600 Utilities Index fund had average daily turnover of EUR 0.42 million and an average bid-offer spread of 0.48% on the Paris market in 2009. Meanwhile, the streetTRACKS MSCI utilities ETF had far lower turnover (EUR 0.05 million) and a much wider average bid-offer spread of 1.23%. Given that our price-to-fair value ratio shows no difference in current valuations between the two indices, we would prefer to invest in a fund tracking the index that is more widely followed, as competition amongst providers will likely keep expense ratios low and competition amongst market makers will serve to ensure better liquidity and help to minimise trading costs.
There are currently eight ETFs trading in Europe that track the DJ STOXX 600 utilities index. Here are they are, along with their vital statistics:
Choosing the Right One
In selecting a fund from the eight listed above let's first look at costs. Remember, your costs aren't limited to the headline total expense ratio, but also things like trading costs (more liquid funds will tend to have narrower bid-offer spreads and be less costly to trade) and tracking error (it is obviously preferable that the fund mimic the returns of its reference index as closely as possible). While trading costs are a crucial consideration, they become less important the longer your expected holding period becomes.
In the above table we can see that the group has fairly similar expense ratios, with the lone outlier being the physical replication version of the iShares fund. The higher TER (0.52%) for this fund versus the group (and notably the swap-based version from iShares) can be largely explained by the incremental costs associated with physically replicating the index. The ComStage ETF wins the award for lowest TER of the bunch with an annual fee of 0.25%.
Liquidity will be an important determinant of trading costs. In the table above, we have included the average daily trading volume (in shares) for each fund on its primary exchange through the first two months of the year to serve as a proxy for liquidity. Here we can see that the iShares physical replication fund is--as measured by average daily trading volume--the most liquid of the group. It is worth noting, however, that on-exchange trading data remains an incomplete measure of ETF liquidity in Europe, as by some estimates only about one third of total ETF trades are actually reported.
Another important choice is deciding between a capitalising and a distributing fund. A capitalising fund will reinvest dividend income from the underlying securities back into the fund and track the total return of the STOXX 600 Utilities Index. Meanwhile, a distributing fund will detach a dividend for shareholders (annually in the case of the iShares and Lyxor funds) to reinvest as they see fit and track the price return of the index. Given that the current expected returns on reinvested dividend income are somewhat small (recall that, based on our stock analysts' fair value estimates, the price/fair value ratio for the index is about 0.97 and therefore implies limited upside) it may be preferable to opt for a distributing version of the fund. However, tax considerations are critical, and you should consider the tax treatment of any dividend payments that you receive in weighing these options.
