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Summary VPU has a respectably low correlation to SPY, but the correlation and relative volatility have changed materially over time. The ETF is great for improving diversification benefits across the portfolio. The expense ratio and dividend yield are both great. If an investor is already using a large bond holding to diversify their portfolio, the benefits from adding VPU to the equity section won’t be as strong. A substantial portion of my analysis will use modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification at the portfolio level. In this article I’m reviewing the Vanguard Utilities ETF (NYSEARCA: VPU ). In my past analysis on other utility ETFs I have found they can offer some nice benefits to the portfolio from lower levels of volatility and lower levels of correlation to the S&P 500. However, finding a good utility ETF can be a problem because a high expense ratio can destroy a fund that would otherwise be very attractive. Since VPU has an expense ratio of only .12%, I’m feeling pretty optimistic going into this one. Does VPU provide diversification benefits to a portfolio? Each investor may hold a different portfolio, but I use the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) as the basis for my analysis. When I ran a regression on SPY and VPU, I found a correlation of 77%. That isn’t very low, but it is not high enough to be problematic. On the other hand, the annualized volatility of VPU since January 2004 was 17.6% compared to SPY having an annualized volatility of 19.4%. Since the sample size includes both very solid bull markets and harsh bear markets, it should be providing a reasonable indication of the relative level of volatility implicit in each investment. However, if an investor focuses only on the last couple of years the resulting volatility levels are significantly less favorable for VPU. Over the last 26 months the annualized volatility on VPU was 14% and it was only 11.3% on SPY. On the other hand, during those 26 months the correlation was only around 52% rather than the longer term average of 77%. Yield & Taxes The yield is 3.35%. That may not sound incredibly high, but it isn’t bad either. Higher yields on the ETFs are nice because they reduce the incentive for human error. Many investors materially underperform the S&P 500 because of a human tendency to buy high and sell low. Having an ETF with a high dividend yield encourages investors to avoid selling off their shares when prices fall. The benefit here could be considered a placebo effect, but so long as it encourages investors to hold onto their equity through the downturn the result is more wealth in the long run. Expense Ratio The ETF is posting .12% for an expense ratio. What else is there to say? That is a solid expense ratio. Largest Holdings The diversification within the ETF is pretty weak. For a very long term holder it might make sense to replicate the ETF by just buying the underlying securities and taking higher trading costs to eliminate the expense ratio. However, an expense ratio of only .12% would be difficult to beat without a fairly long time horizon or a large volume of commission free trades in the account. (click to enlarge) The major holdings here are the same ones I would expect to see. Duke Energy Corporation (NYSE: DUK ) is a fairly huge utility company and frequently at the top of the list for utility ETFs. All around this appears to be a reasonable portfolio for an investor that wants to get more utility companies into their portfolio without having to buy the companies individually. Conclusion Utility companies can act as a form of income investment because of their strong dividend yields. Unlike buying into a bond portfolio investors can expect that the level of dividends will be increasing over time which makes up for the portfolio having more risk than a simple bond portfolio. When it comes down to designing an ideal portfolio, I think there is a viable argument for running a higher allocation to the utility sector as a way to improve diversification throughout the portfolio. The biggest weakness for using utility companies as a way to diversify the portfolio is that the diversification benefits of the utility allocation are not as strong as the benefits from simply using a diversified bond portfolio since bonds have historically shown materially lower correlations with the S&P 500. If an investor already has a large allocation to bonds, the benefits of adding VPU will not be as strong. On the other hand, if an investor places a high value on getting qualified dividends as a source of income, it would materially increase the relative attractiveness of VPU. In those cases, it would make sense to use a stronger allocation to VPU to reduce portfolio risk. 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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