When investors think of the utilities sector, with the eighth-largest weight in the S&P 500, a few thoughts usually come to mind. The sector is usually prized for its above-average dividend yields and defensive nature. In fact, utilities stocks are historically so defensive that the sector is viewed as a bond proxy. And, no exchange-traded fund (ETF) embodies what investors love about the sector more than the Utilities SPDR (ETF) (NYSEARCA:XLU).
Why? To begin with, it’s the largest ETF tracking utilities stocks. XLU debuted in 1998 as part of the broader SPDR suite of sector ETFs. Today, the Utilities SPDR is widely viewed as the benchmark among utilities ETFs, as highlighted by the fund’s more than $7.2 billion in assets under management.
There are less-expensive alternatives to XLU, but with an annual fee of 0.14%, or $14 on a $10,000 investment, it’s fair to call XLU inexpensive. The fund’s expense ratio is below average for the broader ETF universe.
XLU tracks the Utilities Select Sector Index, a measure of the large-cap utilities names residing in the S&P 500. The ETF holds 30 stocks with a weighted average market value of $32.8 billion, according to issuer data. XLU’s top 10 holdings combine for about 60% of the ETF’s weight, and include NextEra Energy Inc (NYSE:NEE), Southern Co (NYSE:SO), and Duke Energy Corp (NYSE:DUK).
Beware XLU, the Bond Proxy
As noted earlier, XLU and the utilities sector are viewed as proxies on bonds. In fact, many income investors are apt to prefer this fund because it has a dividend yield typically in the 3%-4% range, well above the yield on 10-year U.S. Treasuries.
However, XLU’s high-yielding ways make it vulnerable to increases in interest rates. In fact, no sector is as inversely correlated to rising Treasury yields as utilities. The conventional wisdom is as follows: “Why take the risk on equities, even slow-moving utilities, when comparable yields can be had on safer fixed income investments?”
Investors’ pensiveness regarding utilities against a backdrop of rising interest rates was on display in the first quarter of this year as they pulled more than $330 million from the rate-sensitive XLU.
Another rub with the utilities sector is that it is often proof of the adage that financial markets never give away a free lunch. Lower betas and higher dividend yields are nice, but those traits come at a cost with the utilities sector. Utilities typically trade at premiums to the broader market, indicating that there is a price to pay when playing defense and hunting for income.
More from InvestorPlace
- Financial Select Sector SPDR Fund (XLF): The Quick Guide to XLF
- iShares MSCI Emerging Markets Indx (ETF) (EEM): The Quick Guide to EEM
- PowerShares QQQ Trust, Series 1 (ETF) (QQQ): The Quick Guide to QQQ