Utilities have long been prized by investors for their steady income-generating ability. Steady fixed costs and staple revenue generation allow them to push much of their cash flows back to investors in the way of dividends. As such, they’ve earned the name ‘widow and orphan’ stocks, as they are held in high esteem by those who need investment income to live. But most investors treat the sector with a wide brush stroke, citing that most power or water producers are very similar in nature. As such, they own them via passive means.
But they may want to rethink that stance.
The utility sector is quickly turning into a dynamic industry, with some players offering growth, income and better returns. For investors, this means that active management may be a better solution to hone in on these opportunities and generate better-than-average returns in the sector. They could score higher income as well.
A Wide Brush Stroke
It’s easy to see the appeal of utility stocks in a portfolio. Consumers and enterprises need to heat their homes, power their lights, and flush their toilets, no matter the economic environment. This leads to steady cash flows. Those cash flows are met with relatively fixed costs of doing business. Regulatory commissions and rules can allow for future known-in-advance rate hikes. As such, it’s easy for utilities to estimate future cash flows and meet current needs. With that, they are able to pass on much of their excess cash flows as dividends to their shareholders.
Yields in the sector often top 4%.
Because of this stability, utilities are often compared to bonds and fixed income asset classes. So, investors such as retirees, endowments, pensions, and other income seekers often turn to the sector as a complement to their bond holdings.
However, history is perhaps placing a lens of sameness across the utility sector. After all, electricity and natural gas are fungible commodities. In that view, many modern investors have chosen to get their utility fix via passive means. Nearly $25 billion sits in the top three utility ETFs: Utilities Select Sector SPDR Fund, Vanguard Utilities, and iShares U.S. Utilities ETF.
There’s nothing wrong with that approach, but the utility sector may be a case where active management is better.
The Hallmarks of Market Inefficiencies
On the surface, the producers of electricity, distributors of natural gas, and wastewater treatment firms may all look similar. But deep down there are numerous factors to exploit. These are just the kinds of data points active managers can tackle and help drive returns.
For example, operating areas alone can provide great differences in potential.
Because they provide a public good, utilities face plenty of regulatory oversight. But that oversight isn’t equal across the country. Currently, there are 54 public utility commissions in the United States, plus the Federal Energy Regulatory Commission (FERC), which regulates across interstate lines. They all place different regulation requirements upon their utilities. Some states are more strict in terms of rate hikes, while others are more lenient or use market-based pricing. All of these factors play into a utility’s growth and profits.
Moreover, a utility’s operating region can be exploited. Often, utilities have monopolies in their region. However, if the region is performing poorly economically, owning all the power lines is a lesson in futility. Focusing on strong operating regions and their utilities can provide years’ worth of revenue growth.
And speaking of that growth, renewables and data center demand are fueling a new wave of growth for the sector. Advances in AI and data center demand are expected to spur long-term electricity demand. However not all utilities will participate in this demand. Distance to data center hotspots and hyperscalers like Amazon and Microsoft will benefit some utilities while passing others by.
The same could be said for renewables. Solar and wind energy has quickly been tapped by many utilities to meet clean energy requirements. Often, regulators allow utilities to pass on costs via rate hikes, while subsidies provide additional profit margins. But again, not all utilities are making the switch. For example, AEP still expects to generate nearly 30% of its electricity from coal, its largest percentage of capacity.
Active Finds the Winners
This is where active management can unlock better opportunities. Some sectors of the market—like bonds, small-caps, and emerging markets—feature similar inefficiencies as utilities. Investors often paint these segments with a wide brush stroke. Active managers can make a difference in returns. And it looks like the same could be said for utilities given their own exploitable factors.
The proof is in the pudding.
According to asset manager Brookfield and Morningstar data, the average active utility fund has managed to beat the average passive fund over rolling one-, three—, and five-year periods, sometimes by as much as 1.5 percentage points. This chart sums up Brookfield’s findings. 1
In addition to exploiting the sector’s differences, Brookfield highlights that active managers can be defensive, fleeing to cash when rates rise. Thanks to their bond proxy nature, utilities sell off when interest rates rise. Active managers can get ahead of this fact, while passive indexing cannot. This has allowed them to capture just 65% of the sector’s downside versus passive funds. Reaves Asset Management data also shows that active utility management has long provided investors with lower volatility than the broader S&P 500 and passive utility indexing.
Essentially, by going active with their utility holdings, retirees can grab bigger returns, find higher yields, and limit their losses. This only enhances the appeal of the sector.
Getting that active touch in ETF form may be a bit difficult, at least in terms of the number of fund choices. Currently only one exists: the Virtus Reaves Utilities ETF. But its performance has been great and it has managed to beat the sector’s benchmark since its launch.
Utility ETFs
These ETFs were selected based on their low-cost exposure to the utility sector. They are sorted by their YTD total return, which ranges from 3.9% to 9.6%. They have expenses between 0.08% and 0.64%, and assets under management between $40M and $13.2B. They are currently yielding between 2.5% and 3.5%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| UTES | Virtus Reaves Utilities ETF | $41.6M | 9.6% | 2.47% | 0.49% | ETF | Yes |
| VPU | Vanguard Utilities ETF | $6.05B | 5.7% | 3.52% | 0.10% | ETF | No |
| FUTY | Fidelity MSCI Utilities Index ETF | $1.6B | 5.7% | 3.34% | 0.08% | ETF | No |
| XLU | Utilities Select Sector SPDR ETF | $13.2B | 5.6% | 3.43% | 0.09% | ETF | No |
| FXU | First Trust Utilities AlphaDEX Fund | $216M | 3.9% | 2.55% | 0.64% | ETF | No |
The Bottom Line
The utilities sector is a great place for investors to find stability and income. However, the best way to access it may not be through passive means. Active management can play a big role in delivering better returns over the long term, while limiting volatility. Investors looking to invest in the sector for its stability would do well to go active with their utility choice. Luckily, the growth of ETFs is helping spur that adoption.
1 Brookefield (September 2023). Why Active Management Matters for Listed Infrastructure