The Standard & Poor’s 500 Index declined 5.07 percent in January, and the tech-heavy Nasdaq is fairing even worse with a loss of 14.45 percent as of February 10. The integrity of global bank balance sheets, interest rate uncertainty, China’s slowdown and tumbling oil prices have unsettled investors. While the overall market has been under selling pressure, the Vanguard Utilities ETF (VPU) and the company’s Telecommunication Services ETF (VOX) have defied the downward trend: VPU has risen 7.12 percent, and VOX has rallied over the past month and is currently down only 2.31 percent. This month we look at the viability of these two funds.
Vanguard Utilities ETF
Utilities deliver stable cash flows and attractive yields that can mimic the protection of bonds. Vanguard Utilities ETF (VPU) is an appealing low-cost option for income investors seeking broad exposure to U.S. utility companies. This four-star Morningstar-rated fund uses a market-cap weighting strategy; larger firms held within the portfolio have more influence over performance. VPU will generate better returns when large- and mid-cap names are outperforming. Large caps are handily beating small caps in 2016, which benefits VPU.
The portfolio is designed to track the MSCI US Investable Market Utilities 25/50 Index. The fund has 82 individual holdings, with an average market cap of $14.6 billion. The benchmark average is slightly more than $17 billion. VPU has a 54 percent exposure to large-cap stocks as well as a 35 percent allocation to mid-caps and an 11 percent small-cap allotment. While the price-to-book ratio is 1.58, the price-to-earnings ratio is 16.22. The top five holdings, Duke Energy (DUK), NextEra Energy (NEE), Southern Co (SO), Dominion Resources (D) and American Electric Power (AEP), make up 48 percent of assets. These are followed by PG&E (PCG), Exelon (EXC), PPL Corp (PPL), Sempra Energy (SRE) and Public Service Enterprise Group (PEG).
Utilities were regarded as reliable, income-generating stocks prior to deregulation in 2000 and a long interest rate decline. The sector was a strong performer for a time in the 2000s, but in recent years it has suffered with the anticipation of rising interest rates. The recent modification in rate expectations has benefited the sector greatly. VPU has 1-, 3- and 5-year total returns of 4.36 percent, 12.10 percent and 11.96 percent, respectively, compared with the category averages over the same periods of -4.83 percent, 11.56 percent and 10.96 percent. Over the past 10 years, VPU’s standard deviation of 13.6 is lower than the S&P 500 rating of 15.1 percent, but over the past three years it has been more volatile due to swings in rate expectations.
VPU has a 0.1 percent expense ratio compared with the category average of 1.24 percent.
Investors should watch the utilities space closely. Although dividends are generally safe and compose a large portion of total returns, the sector is dependent on many factors. Lower energy demand, higher costs for coal and nuclear power generation, the low price of natural gas, and new environmental regulations can all impact the sector. The sector is undergoing consolidation as companies look for favorable cost synergies and greater investment opportunities, which is positive for share prices.
Vanguard Telecommunication Services ETF
The four-star Morningstar-rated Vanguard Telecommunications Services ETF (VOX) provides investors with concentrated exposure to the domestic telecom industry. The fund seeks to track the performance of the benchmark MSCI US Investable Telecommunications Services 25/50 Index. In addition to telecom providers, the portfolio of 31 stocks includes a tower operator and an information technology services firm. The ETF utilizes a market-cap weighted strategy that creates a top-heavy portfolio with the top 10 holdings accounting for the vast majority of funds under management. The top two holdings, AT&T (T) and Verizon (VZ), compose nearly 50 percent of the portfolio.
Large telecom firms, especially those with a history of stable or growing dividends, offer above-average yields, attracting income-oriented investors. While 31 percent of assets are allocated to small-cap firms, the fund has a 59 percent exposure to large caps and a 9.5 percent allotment toward mid-caps. VOX has an average market cap of $21.13 billion, a price-to-book ratio of 2.23 and a price-to-earnings ratio of 14.99.
VOX has generated total 1-, 3- and 5-year returns of -3.33 percent, 7.69 percent and 7.88 percent, respectively, compared with the category averages over the same periods of -8.80 percent, 5.54 percent and 4.76 percent. The fund has a 3-year standard deviation of 11.95. VOX also has an extremely low 0.10 percent expense ratio versus the category average of 1.47 percent.
The telecom sector is a mature industry, though evolution continues. People are still exchanging landlines for cell phones, and mobile devices are increasingly used for data. The wireless infrastructure is built out, reducing future capital expenditures, which enables companies to generate significant cash flows and pay dividends. There is also a new round of consolidation driving greater economies of scale. How much more consolidation can occur is difficult to determine, as the Federal Communications Commission is working to preserve the current competitive environment.
Outlook
In light of the current market and interest rate environments, investors should use caution with these defensive sectors. The Federal Reserve has begun a rate-hike cycle, and both utilities and telecom are highly indebted industries. They are able to borrow large sums against stable cash flows, increasing their susceptibility to rising rates.
While telecom’s upside is not as great amid a falling market, the risk of missing out on a reversal is lower. VOX is dominated by its top two holdings, leaving it particularly vulnerable to the performance of these two companies. Some investors may prefer owning only those two shares instead of the ETF in favor of higher yields.
For income investors looking toward the long term, a good offense beats defensive strategies. Vanguard’s High Dividend Yield (VYM) offers diversified exposure to the market with a competitive 3.4-percent yield. VYM will not deliver the upside potential of utilities if rates drop, but it will participate in a rally when the market heads higher. Another fund to consider is perennial favorite Dividend Appreciation (ETF: VIG, Mutual Fund: VDADX). While it may not attract short-term income investors with its lower yield of 2.4 percent, it has grown dividends faster over the long haul and holds up well during bear markets.
Both funds may perform well as long as investor uncertainty continues. Nevertheless, these safe-haven investments can quickly reverse if sentiment improves. For that reason, we continue to issue Hold recommendations on each fund; investors may quickly shed these positions as they become increasingly bullish.