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Summary IDU offers exposure to a great sector, utilities, which is excellent for portfolio diversification. The ETF had about 61 holdings, which is fine until you consider that VPU has 83 and the expense ratio is less than a third as high. The largest exposure is to electric utilities, but the breakdown within the utility sector would be better if “multi-utilities” were broken down by source of revenue. As I’m looking over the possible ETF exposures, I’d like to evaluate several options for utility exposure. Utilities are often poorly represented in ETFs and that trend can even occur in ETFs focused on high dividend yields. That can be a shame because utilities are a nice holding for many investors since they provide high yields, moderate levels of volatility when used in a diversified portfolio, and they allow investors to own the producer of a major personal expense. Of course, the expense I’m talking about is the utility bills. So long as the investor is human (a safe assumption?) they are likely to be purchasing the services of one utility company or another. Even if the investor decides to retire in an apartment that includes utilities in the rent, a long term increase in utility costs could drive up rents. Some people may opt to live off the grid with solar power and drink their water from a well, but I’d wager that is a very small portion of my audience. One of the funds that I’m considering is the iShares U.S. Utilities ETF (NYSEARCA: IDU ). Expense Ratio Investors are already paying for the utilities flowing into their house and the utility companies are paying for their own management and infrastructure. It would seem very unfortunate if investors had to add another layer of costs onto their investment by having a high expense ratio. Unfortunately, that high expense ratio is present in IDU as the ETF reports an expense ratio of .43%. No, I don’t care for that expense ratio one bit. For comparison, the Vanguard Utilities ETF (NYSEARCA: VPU ) has an expense ratio of .12%. Can you guess which one I’d rather be paying? It shouldn’t be hard. Largest Holdings The following chart shows the top 25 holdings of IDU and their respective portion of the portfolio. The total portfolio only holds 61 companies, so this is a very substantial portion of the holdings. For comparison, VPU had 83 holdings. The holdings list is fairly standard. In short, the top 10 holdings are the same as the top 10 holdings for VPU and the top 8 are in the same order for each ETF. This appears to be a fairly standard utility ETF. Within the Sector The following chart classifies the holdings based on which part of the utility sector they fall into: I find this chart to be much more interesting than the one that simply breaks it down by company because this method shows at a glance what those companies are producing. There is one weakness to the presentation though because “Multi-Utilities” is not very specific and it represents over 34% of the portfolio. It would be great if the individual companies could be broken down by the portion of their revenue coming from electric, gas, and water services. Then those percentages could be aggregated back to the portfolio level and it would give investors a better feel for how well they could match their ownership of the producers with their own individual bills. From an investment level, that isn’t really necessary but it would be interesting to do and it might encourage investors to save more. Designing an intelligent portfolio structure is very important, but being engaged and making the choice to fund that portfolio is also very important. The biggest weakness I see for many young workers today is a lack of engagement in investing. Using a “hands off” strategy with allocating a large amount of money to Vanguard target date funds is a fine investment strategy. I believe it would outperform many individual investors, but it still relies on having enough engagement to actually follow through with funding the account. Building the Portfolio This hypothetical portfolio has a moderately aggressive allocation for the middle aged investor. Only 30% of the total portfolio value is placed in bonds and a third of that bond allocation is given to high yield bonds. This portfolio is probably taking on more risk than would be appropriate for many retiring investors since the volatility on equity can be so high. However, the diversification within the portfolio is fairly solid. Long term treasuries work nicely with major market indexes and I’ve designed this hypothetical portfolio without putting in the allocation I normally would for REITs on the assumption that the hypothetical portfolio is not going to be tax exempt. Hopefully investors will be keeping at least a material portion of their investment portfolio in tax advantaged accounts. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. (click to enlarge) A quick rundown of the portfolio The two bond funds in the portfolio are the PIMCO 0-5 Year High Yield Corporate Bond Index ETF (NYSEARCA: HYS ) for high yield shorter term debt and the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) for longer term treasury debt. TLT should be useful for the highly negative correlation it provides relative to the equity positions. HYS on the other hand is attempting to produce more current income with less duration risk by taking on some credit risk. The Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ) is used to make the portfolio overweight on consumer staples with a goal of providing more stability to the equity portion of the portfolio. is used to create a significant utility allocation for the portfolio to give it a higher dividend yield and help it produce more income. I find the utility sector often has some desirable risk characteristics that make it worth at least considering for an overweight representation in a portfolio. The iShares MSCI EAFE Small-Cap ETF (NYSEARCA: SCZ ) is used to provide some international diversification to the portfolio by giving it holdings in the foreign small-cap space. The core of the portfolio comes from simple exposure to the S&P 500 via the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), though I would suggest that investors creating a new portfolio and not tied into an ETF for that large domestic position should consider the alternative by Vanguard’s Vanguard S&P 500 ETF (NYSEARCA: VOO ) which offers similar holdings and a lower expense ratio. I have yet to see any good argument for not using or another very similar fund as the core of a portfolio. In this piece I’m using SPY because some investors with a very long history of selling SPY may not want to trigger the capital gains tax on selling the position and thus choose to continue holding SPY rather than the alternatives with lower expense ratios. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. Despite TLT being fairly volatile and tying SPY for the second highest volatility in the portfolio, it actually produces a negative risk contribution because it has a negative correlation with most of the portfolio. It is important to recognize that the “risk” on an investment needs to be considered in the context of the entire portfolio. To make it easier to analyze how risky each holding would be in the context of the portfolio, I have most of these holdings weighted at a simple 10%. Because of TLT’s heavy negative correlation, it receives a weighting of 20% and as the core of the portfolio SPY was weighted as 50%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the S&P 500. Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. Conclusion IDU is offering investors exposure to the utility sector which can deserve being slightly overweight in a portfolio. For ETF investors, it may be hard to get enough utility exposure without specifically buying utility ETFs. From the perspective of risk in the portfolio it looks desirable to include IDU. The fund has only limited correlation and moderate volatility which makes it a nice fit. However, the presence of VPU offering more diversification and significantly lower expense ratios makes the use of IDU questionable. If investors had few ETF options, I would consider IDU superior to having poor diversification. Since investors have a plethora of choices for broad market exposure and even a few decent options for utility sector exposure, I’d rather avoid IDU in favor of VPU. More diversification in the holdings combined with a much lower expense ratio would make it fairly difficult for IDU to outperform VPU over the next twenty years unless there was either a material change in the expense ratios or in the holdings. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. Scalper1 News
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