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How much should retirees invest in utility stocks?
The typical advice from financial planners is to have a healthy allocation to the sector, since utilities usually pay a handsome dividend and have below-average volatility. On both counts, these stocks appear to be tailor-made for retirees.
Yet the sector (as represented by the Utilities Select Sector SPDR ETF XLU, +0.01% ) has struggled over the last decade, lagging behind the S&P 500 SPX, +0.40% by 4.0 annualized percentage points. The second quarter of this year was especially tough, with the XLU barely making any money (a gain of just 2.7%) while the S&P 500 was surging 20.2%.
For this column, I am taking a deeper dive into the historical data to come up with some insight. I want to decompose the XLU’s returns, examining which of the well-known factors (each is known as a “smart beta”) play a role in its performance.
The reason to engage in this factor analysis is to gain a greater understanding of why utilities have performed in the way they have. This in turn should allow us to make a more informed judgment about the sector’s future prospects.
I fed into my PC’s statistical software the XLU’s monthly returns over the last 20 years, along with the comparable returns of each the following seven well-known factors. My goal was to see which of them were correlated with the XLU.
• Small-cap effect (the tendency for small-caps to outperform large-caps)
• Value effect (the tendency for value stocks to beat growth)
• Profitability (the tendency for firms to do better to the extent they historically have been more profitable)
• Investment (the tendency for firms to do better to the extent they invest conservatively rather than aggressively)
• Momentum (the tendency for stocks that have performed the best over the recent past to continue doing so for a few months longer)
• Low Volatility (the tendency for stocks to do better to the extent their past volatility has been lower)
• Quality (the tendency for stocks with higher financial quality and better balance sheets to do better than those with lower quality)
Surprisingly, I found just two of these factors to be correlated with the XLU at the 95% confidence level that statisticians often use when determining whether a pattern is genuine: Low Volatility and Quality.
This means that, when you invest in a utility portfolio, you are not making particular bets in terms of the other five factors. You’re not skewing toward the large- or small-cap extremes of the spectrum, for example; nor are you tilting toward growth over value, or vice versa.
You are making a bet on the Low Volatility factor, however. That makes sense, since utility stocks tends to be less volatile than that of the overall market; some even call them boring. But this is a virtue, not only because retirees are risk averse but also because, historically, low-volatility stocks have outperformed the most volatile issues.
The other factor you’re betting on with utilities is Quality, but in just the opposite way than what you might think: The correlation between the utility sector and the Quality factor is inverse, which means that utility stocks tend to be skewed toward the opposite end of the spectrum from quality. In other words, with utilities you are betting against Quality.
That surprised me, so I reached out to Nicolas Rabener, founder of the London-based firm FactorResearch. In an email, he explained that utility companies typically employ a lot of leverage, and for that reason they are considered lower quality.
What all this means: A portfolio of utility stocks provides you with the ability to invest in companies with a lot of leverage without incurring much volatility. That’s unique, since you’d otherwise expect the stocks of highly-leveraged companies to be especially volatile. But not with utilities.
Over the longer term, at least, it’s been a winning combination to combine these two bets in this way. According to FactSet, the XLU has beaten the S&P 500 by the annualized margin of 7.6% to 6.2% over the last 20 years, as you can see from the accompanying chart. (Both of these returns include reinvested dividends.)
In theory, you should be able to duplicate the utility sector’s performance by investing in just the right combination of smart-beta ETFs. But it would be difficult to do that in practice, since it would require going short a quality factor ETF. Far easier and more straightforward to simply invest in the utility sector itself.
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How will these two factors perform in the future?
But what about the future? Let’s first focus on Low Volatility, since this is an area of the market that has struggled over the last couple of years. Since two months ago I devoted a whole column to this factor, I won’t repeat my analysis here. But I concluded then that you should continue to give Low Volatility approaches the benefit of the doubt.
So far so good.
The Quality factor is another story, however. Historically, according to research from Clifford S. Asness, Andrea Frazzini, and Lasse H. Pedersen of AQR Capital Management, high-quality stocks have outperformed low-quality stocks. This general pattern has not held up over the last two decades, however, which is one reason why utility stocks have benefited by in effect betting against quality. For example, the Invesco S&P 500 Quality ETF SPHQ, +0.43% has lagged behind the S&P 500 by 1.4 annualized percentage points since its inception in 2005.
The best hypothesis I’ve seen for why quality stocks haven’t lived up to their historical reputation is the Federal Reserve’s extraordinary monetary stimulus, which dates back at least to the Great Financial Crisis. That stimulus in effect rewards companies for taking more risk, since they know that the government won’t let an economic downturn get out of hand. Some even refer to this stimulus as the “Fed Put.”
If this hypothesis is correct, and if the Fed Put continues to exist, then it’s plausible that Quality will continue to struggle relative to the overall market. And, if so, that is yet another reason to continue betting on utility stocks in the future.
The bottom line? Despite struggling in recent years to keep up with the market, compelling reasons remain for retirees to continue investing heavily in utility stocks.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.
