1 Defensive ETF to Buy Now Before the Fed Cuts Rates

The Federal Reserve's interest rate policies have been a major influence on market dynamics, with the S&P 500 Index ($SPX) on pins and needles ahead of today's decision. The benchmark index is up 26.5% over the past year and 18% on a year to date basis, and is lingering near record highs - but at the same time, volatility expectations are also picking up. 

The Cboe Volatility Index ($VIX), which reflects investors' expectations for short-term price swings in the SPX, has cooled from its “panic highs” of early August, but still sits about 48% higher than its mid-June levels, as of this writing. This reflects heightened uncertainty on Wall Street, as investors eye softening economic data against still-elevated inflation - leaving the Fed to thread the needle on a soft landing for the U.S. economy.

In times like these, defensive ETFs can be a go-to for investors seeking a safe harbor. These funds are crafted to weather economic storms, offering steady returns even when the broader market is in flux. As the Federal Reserve prepares for what's expected to be a series of rate cuts, the allure of these defensive plays grows stronger amid the nearly palpable uncertainty on Wall Street.

This brings us to a noteworthy development: Bank of America's recent decision to upgrade the utilities sector to “Overweight.” With strong fundamentals and appealing dividend yields, utilities stocks have caught the eye of investors looking for reliable investments - and presents a compelling opportunity to invest in utilities for their resilience, as well as their potential growth in the age of artificial intelligence (AI). 

Let's take a closer look at a top sector-focused ETF to uncover its composition, performance, and the insights driving Bank of America's bullish stance.

Overview of Utilities Select Sector SPDR Fund ETF 

As one of the old-school SPDRs, the Utilities Select Sector SPDR Fund (XLU) is no newcomer to the ETF space. Launched in 1998, XLU has grown to manage $18.5 billion in assets, making it a heavyweight in the exchange-traded fund (ETF) market. 

Managed by State Street Global Advisors, XLU is designed to track the performance of the Utilities Select Sector Index, focusing on companies within the electric utilities, water utilities, and multi-utilities sectors. The fund's strategy is straightforward; to replicate the performance of its benchmark index. Given the stable demand for utilities, this approach positions XLU as a defensive play, which is particularly appealing during times of market uncertainty.

XLU's portfolio is spread across 31 holdings. The top 10 stocks account for about 59% of the total portfolio, highlighting its focus on major utility players. NextEra Energy Inc. (NEE) leads the pack with a significant 14.59% weighting, followed by Southern Company (SO) and Duke Energy (DUK) at 8.16% and 7.50%, respectively. Other top holdings include Constellation Energy (CEG) (5.28%), American Electric Power (AEP) (4.57%), and Sempra (SRE) (4.42%). This concentration underscores XLU's emphasis on stability and reliable income.

In terms of performance, XLU has outpaced the broader market in 2024, with a year-to-date gain of nearly 25%. 

Investors are drawn to XLU not only for its stability but also for its attractive dividend yield of 2.77%, based on the quarterly dividend of $0.56. This yield is nearly double that of the broader S&P 500, making it a compelling choice for income-focused investors. 

Furthermore, XLU maintains a low expense ratio of 0.10%, which is well below the category average, enhancing its appeal as a cost-effective investment option.

The fund also enjoys strong liquidity, with an average daily trading volume of about 8.5 million shares. This high volume ensures that investors can enter and exit positions quickly with minimal slippage, a crucial factor in volatile markets.

Impact of Fed Rate Cuts

When the Federal Reserve decides to cut interest rates, it sets off a chain reaction that affects various facets of the economy. Lower rates make borrowing money cheaper, encouraging both consumers and businesses to spend and invest more. This increased activity can stimulate economic growth, providing a much-needed boost, especially when the economy is slowing down.

For the utilities sector, which is tracked by the XLU ETF, rate cuts can be particularly advantageous. Utilities are capital-intensive, relying heavily on borrowing to fund infrastructure projects and maintain operations. With lower interest rates, these companies face reduced borrowing costs, enhancing their profitability and making them more appealing to investors seeking steady returns. This is particularly crucial now, as energy demands from AI are ramping higher.

Historically, utilities and other high-dividend sectors perform well when interest rates decline. Lower rates make high-dividend stocks more attractive than fixed-income investments like bonds, whose yields drop in tandem with rate cuts. As a result, investors often flock to utility stocks for their reliable dividends, further driving up stock prices in this sector. 

More broadly, data shows that on average, U.S. stocks have delivered an 11% real return in the 12 months following the start of a rate-cutting cycle, outpacing bonds and cash. This trend underscores the potential for growth in sectors like utilities, which are poised to benefit from improved market conditions and their inherently defensive characteristics.

Conclusion

In conclusion, the Utilities Select Sector SPDR Fund (XLU) stands out as a smart choice for investors seeking both stability and income, especially as the market anticipates potential Federal Reserve rate cuts. With its strong performance, attractive dividend yield, rising electricity demand, and low expense ratio, XLU offers a compelling defensive strategy in uncertain times. Bank of America's upgrade of the utilities sector underscores this potential, making now an opportune moment to consider utilities as a cornerstone of your investment portfolio. 

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On the date of publication, Ebube Jones did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.