We recommend investors avoid all utility sector ETFs. We found no ETFs in the utility sector that offer investors attractive investment merit and acceptable structural integrity. We rate the investment merit of the top-5 utility sector ETFs.

Per our first-quarter-2011 review of U.S. Equity Sector ETFs, the utility sector is one of five sectors that gets our “neutral” rating. Figure 2 shows how the utility sector’s stocks and the market value attributed to them stack up under the microscope of our risk/reward rating system. Only two companies in this sector get our “attractive” rating while five are ranked “very dangerous”.

Figure 1: Utility Sector – Capital Allocation & Holdings by Risk/Reward Rating

Sources: New Constructs, LLC and company filings

The utility sector has 38% of its value invested in dangerous-or-worse-rated stocks and only 4% of its value invested in attractive-or-better-rated stocks. Relatively high allocation to dangerous-or-worse-rated stocks causes the utility sector to earn our neutral overall risk/reward rating.

The key takeaway is that the utility sector offers very few good investment opportunities because there are so few attractive-or-better-rated stocks in the sector. The investment value of each ETF is derived from its constituents, so ETFs that overweight attractive-or-better-rated stocks are great investment opportunities while ETFs that overweight neutral-or-worse-rated stocks should be avoided.

When analyzing the utility sector ETFs, we started by identifying those ETFs with acceptable structural integrity as measured by XTF, an ETF research firm. We chose the 5 ETFs whose XTF rating was above the sector average XTF rating.

Figure 2: Utility ETFs With Acceptable Structural Integrity

Sources: New Constructs, LLC; XTF and company filings

Figure 2 shows clearly that not all utility ETFs are made the same. Different ETFs have meaningfully different numbers of holdings and, therefore, different allocations to holdings. Given the differences in holdings and allocations, these ETFs will likely perform quite differently.

After determining the structural integrity, we analyzed the investment merit of each ETF based on how it allocated value to each stock it held. Figure 3 shows how the 5 utility sector ETFs stack up versus each other and the overall sector based on their overall risk/reward ratings and the allocation of their holdings by rating.

Figure 3: Investment Merit Based on Holdings and Allocations

Sources: New Constructs, LLC; XTF and company filings

Attractive ETFs:

We find no Attractive-or-better-rated Utilities ETFs.

Neutral ETFs:

Three Utilities ETFs allocate the value of the fund in a way that earns them a Neutral Overall Risk/Reward rating: XLU, IDU, and VPU. We recommend investors buy the Very Attractive and Attractive stocks in this sector before buying any of the Utilities ETFs we cover in this report. Contact us for the full list Utilities companies that earn an Attractive-or-better Overall Risk/Reward rating.

Dangerous ETFs:

We recommend investors avoid or sell short UTH and RYU because of their Dangerous-or-worse Overall Risk/Reward ratings. Figure 3 contrasts the difference in investment merit between XLU, RYU, and the overall sector.

Benchmark Comparisons

Sector Benchmark

XLU has similar ratings to the overall Utilities sector. XLU has a market-implied Growth Appreciation Period (GAP) of 7 years compared to the overall sector’s GAP of 11 years. XLU’s shorter GAP makes it a more attractive investment than the overall sector.

Figure 4: XLU – Risk/Reward Rating

Sources:   New Constructs, LLC and company filings

Figure 5: Utilities Sector – Risk/Reward Rating

Sources:   New Constructs, LLC and company filings

XLU more effectively allocates capital than the overall Utilities sector. Per Figure 3 above, XLU allocates only 4.1% of its value to Attractive-or-better-rated stocks while the sector allocates only 3.8%. XLU also allocates 31% of its value toward Dangerous-or-worse-rated stocks compared to the sector’s Dangerous-or-worse weightings of 37%.

For explanation and details behind our risk/reward rating system, see one of our Company Valuation reports, which are available for free here.

Market Benchmark

The S&P 500 outperforms XLU in quality of earnings ratings. XLU earns a Neutral Economic vs. Reported Earnings rating while the S&P 500 earns a Very Attractive Economic vs. Reported Earnings rating because its Economic Earnings are positive and rising.

XLU outperforms the S&P 500 in valuation ratings. XLU has a Price-to-EBV of 1.1, earning it a Very Attractive rating, and a GAP of 7 years compared to the S&P 500’s Price-to-EBV of 1.5 and GAP of 24 years.

Figure 6: XLU – Risk/Reward Rating

Sources:   New Constructs, LLC and company filings

Figure 7: S&P 500 – Risk/Reward Rating

Sources:   New Constructs, LLC and company filings

The S&P 500 more effectively allocates capital than XLU. Per Figure 3 above, XLU allocates 4.1% of its value to Attractive-or-better-rated stocks while the S&P 500 allocates 41.3%. XLU also allocates 31% of its value toward Dangerous-or-worse-rated stocks compared to the S&P 500’s Dangerous-or-worse weightings of 23.8%.

Methodology

This report offers recommendations on Utility sector ETFs and benchmarks for (1) investors considering buying Utility sector ETFs and for (2) comparing individual ETFs to the Utility sector and the S&P 500. Our analysis is based on aggregating results from our models on each of the companies included in every ETF and the overall sector (89 companies) based on data as of 04/20/11. We aggregate results for the ETFs in the same way the ETFs are designed. Our goal is to empower investors to analyze ETFs in the same way they analyze individual stocks.

To make an informed ETF investment, investors must consider:

1)    The structural integrity of the ETF and its ability to fulfill its stated objective. We use XTF, an ETF research firm, to find the top 5 ETFs with the best structural integrity rating.

2)    The quality of the ETF’s holdings. We determine and ETF’s quality using our overall risk/reward rating system.

Given the success of our Rating system for individual stocks, we believe its application to groups of stocks (i.e. ETFs and funds) helps investors make more informed ETF and mutual fund buying decisions. Barron’s regularly features our unique ETF research. The first article is “The Danger Within”.