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Summary VUIAX has a respectably low correlation to SPY, but the correlation and relative volatility have changed materially over time. The expense ratio is great for an investor wanting some cheap diversification throughout the utility sector. I expect the Federal Reserve to push hard for raising rates in December, but I don’t think rate increases can be sustained. Utilities are sensitive to interest rates, so an increase in rates would trigger lower prices and a buying opportunity. In my past analysis on other utility mutual funds and 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 mutual fund can be a problem because a high expense ratio can destroy a fund that would otherwise be very attractive. Since the Vanguard Utilities Index Fund (MUTF: VUIAX ) has an expense ratio of only .12%, I’m feeling pretty optimistic going into this one. Does VUIAX 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 VUIAX, I found a correlation of 78%. That isn’t very low, but it is not high enough to be problematic. I found the annualized volatility for VUIAX was 18% since February of 2004, which was slightly lower than the overall market at 19.4% during that time span. However, if an investor focuses only on the last couple of years the resulting volatility levels are significantly less favorable for VUIAX. Over the last 24 months the annualized volatility on VUIAX was 14.8% and it was only 13.1% on SPY. On the other hand, during those 24 months the correlation was only around 53% rather than the longer term average of 78%. Expense Ratio The mutual fund 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 mutual fund is pretty weak. For a very long term holder it might make sense to replicate the mutual fund 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 mutual funds. 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. Why Utilities Investors may be wondering why they should look to raise the utility allocation when the Federal Reserve is talking about raising rates. Since utilities tend to have some material correlation to corporate bond funds, it would seem like an allocation to utilities would be dangerous. When it comes to the Federal Reserve, my stance is that they can’t raise rates as rapidly as they would like to raise them. Because I expect them to substantially underperform their projected trajectory, I see the December meeting as potentially providing a great entry point for equity REITs, utilities, and bonds. I see the potential for weaker prices as being indicative of solid entry points, it simply requires having the conviction to pull the trigger right when everyone else is bracing for higher rates. 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 VUIAX 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 VUIAX. In those cases, it would make sense to use a stronger allocation to VUIAX to reduce portfolio risk. Scalper1 News
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