The S&P 500 and Nasdaq Composite have both put up excellent gains so far this year and are hovering around all-time highs. But surprisingly, the utility sector has produced a total return of 13.9% year to date -- topping the S&P 500 and the Nasdaq Composite.
Vanguard offers low-cost exchange-traded funds (ETFs) for all 11 sectors. Year to date, the Vanguard Utilities ETF (VPU -0.27%) is tied with the Vanguard Communication Services ETF as the best-performing sector this year -- even better than tech.
With an expense ratio of just 0.1%, $10,000 invested in the Vanguard Utilities ETF incurs just $10 in annual fees. Here's why this ETF is an excellent way to invest in the sector, and the pros and cons of buying the fund now.
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A primer on the utilities sector
Utilities comprise just 2.3% of the S&P 500, making them one of the smallest sectors by weighting. The Vanguard Utilities ETF mirrors the performance of the sector, consisting of 62.5% electric utilities, 25.3% multi-utilities, 4.2% gas utilities, 3.8% water utilities, 3.4% independent power producers and energy traders, and 0.9% renewable electricity.
The Vanguard Utilities ETF performed terribly last year, falling by over 10% compared to a 24.2% gain in the S&P 500. Inflation and higher interest rates were major causes of the sector's weak performance.
Many utilities work with regulators and government agencies to set prices, which provides steady cash flow but also limits growth potential. In this vein, utilities don't benefit as much from economic growth, but they are resistant to recessions.
Due to the structure of their business models, utilities tend to pass along most of their profits to investors through dividends. The Vanguard Utilities ETF yields 3.3%, much more than the S&P 500 and most other sectors.
But when the risk-free 10-year Treasury rate is between 4% and 5%, there's a higher opportunity cost to invest in income-focused equities rather than take the sure bet.
When approaching low-growth income stocks, investors want stability and a high yield to compensate for the risk they are taking with equities rather than with bonds or risk-free assets. When low-growth equities yield less than the risk-free rate, their risk/potential reward is relatively less attractive.
Over time, utilities stand to benefit from a growing population and higher energy consumption. And many electric utilities have been investing in renewable energy assets to spur growth. But still, the dividend is the main draw with this type of investment.
Delivering value and passive income
Going into the year, there was hope that the Federal Reserve would begin lowering interest rates, but it remains to be seen when rate cuts will begin, if at all, in 2024. With the 10-year Treasury rate currently at 4.5%, you might be wondering why the Vanguard Utilities ETF has rallied so much this year compared to other sectors.
I think a lot of this is due to the sector being oversold relative to the market in recent years, paired with its high yield and inexpensive valuation. The Vanguard Utilities ETF has a price-to-earnings (P/E) ratio of 22.1 and, as mentioned, a yield of 3.3%. That's an attractive profile compared to the S&P 500's 27.6 P/E and 1.3% yield.
It also stacks up well compared to other safe, low-growth ETFs and stocks. The Vanguard Consumer Staples ETF (VDC -0.54%) has a yield of 2.5%, a P/E of 26.1, and is also hovering around an all-time high. Granted, there are more attractive options within that sector, like Coca-Cola, with its 3.1% yield and 25.3 P/E.
Another sector that stands out as combining value and income is the Vanguard Energy ETF (VDE 0.02%), which yields 3% and has a P/E of just 8.2. It looks too good to be true at first glance, and in some ways, it is.
Oil and gas companies are in expansion mode and are generating outsize profits. When approaching a cyclical sector, it's not a good idea to look solely at the P/E since it can appear dirt cheap during boom times and inflated during a downturn.
Still, the energy sector and the Vanguard Energy ETF could be a better fit for investors who don't mind the volatility of oil and gas and some upside potential from earnings growth, and who want to invest in a value- and income-focused sector.
A good fit for risk-averse investors
Overall, the Vanguard Utilities ETF offers a compelling balance of value and income compared to other ETFs and stocks. The strong performance of utilities indicates that the rally isn't just in growth stocks. There are plenty of stodgy dividend companies that are outperforming the benchmarks and hitting all-time highs.
A lot of sectors and stocks simply aren't as cheap as they used to be, but that doesn't mean investors should smash the sell button or stop putting new capital to work in the market. Despite its low growth, The Vanguard Utilities ETF stands out as an excellent choice if you're looking for a safe place to park your money and earn passive income, but there could be even better sectors out there if you're willing to take on more risk.
