The utilities sector is a classic defensive choice for investors, but the recent performance of stocks in this group is utterly offensive.
The S&P/TSX Capped Utilities Index lost 11 per cent in 2022, 0.4 per cent last year and was off about 3 per cent for the current year through late March. These numbers remind us of the vulnerability of utilities stocks when interest rates are at high levels.
Rates are expected to decline later this year, which would make conditions for utilities stocks more favourable. A quick and easy way to benefit from a turnaround is to buy an exchange-traded fund that holds stocks in the utilities sector.
One option is to simply buy the S&P/TSX Capped Utilities Index using the $331-million iShares S&P/TSX Capped Utilities Index ETF (XUT-T). A clear drawback to this ETF is an expensive management expense ratio of 0.61 per cent. The benefit is a portfolio with a dominant 22-per-cent weighting in an elite stock in the utilities sector, Fortis Inc. (FTS-T).
Fortis has outperformed the utilities index significantly over the past few years and adds some stability to XUT. You can see this when you compare XUT’s return to the $417-million BMO Equal Weight Utilities Index ETF (ZUT-T), where the Fortis weighting is the same as other stocks in the fund at around 7 per cent. XUT lost an average annual 0.9 per cent in the three years to Feb. 29, while ZUT lost 3.7 per cent.
ZUT’s MER is the same as XUT at 0.61 per cent, which tells us the state of fee competition in ETF-land is fierce in some categories, but not all. ZUT’s yield based on its recent distribution is 4.7 per cent, compared to 4 per cent for XUT.
The yield differential reflects the fact that XUT has less exposure to the hardest hit and thus highest-yielding utilities stocks. For example, it has about 9 per cent combined in Algonquin Power Utilities Corp. (AQN-T) and Capital Power Corp. (CPX-T), while ZUT’s portfolio has a weighting of a little more than 14 per cent in these two stocks. Algonquin’s yield is around 7 per cent these days and Capital Power is around 6.4. By comparison, the Fortis dividend yield is around 4.5 per cent.
One more utilities ETF option is the tiny $8.8-million Horizons Canadian Utility Services High Dividend Index ETF (UTIL-T). The MER is – don’t be shocked – 0.61 per cent and the distribution yield is 4.7 per cent. UTIL tracks the Solactive Canadian Utility Services High Dividend Index, which takes a broader view of utilities in its inclusion of stocks like TC Energy Corp. (TRP-T) and Rogers Communications (RCI-T).
High interest rates are weighing on utilities stocks, and so is current stock market sentiment. With stock markets churning out strong returns lately, investors are much more interested in playing offence. This helps explain the dominance of the so-called Magnificent Seven U.S. tech stocks – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla.
The day of the defensive stock will come again, though. In 2020, the year the pandemic took hold, the S&P/TSX Capped Utilities Index had a nice little gain of 15 per cent.