XLU: Join Billionaires Trading Short-Term Pain For Long-Term Gain

The Utilities Select Sector SPDR® Fund ETF (NYSEARCA:XLU) offers investors a low-cost, passive way to gain exposure to the utility sector, a sector that billionaires are investing in quite aggressively. Given that the utility sector is enjoying significant long-term tailwinds but is facing potential short-term headwinds, we’re taking a fresh look at this ETF to see if it is an attractive buy currently for investors who want to invest alongside some of today’s most prominent investors.

Utilities Face Significant Short-Term Headwinds

Firstly, significant challenges remain for the utility sector, and the biggest of these is the higher-for-longer interest rate environment. Utilities are often viewed as bond proxies due to the regulated nature of their cash flows, which makes them generally quite stable and defensive through all economic environments. As a result, higher interest rates suppress utility stock prices during periods of elevated rates because markets require increased dividend and earnings yields from these bond-proxy stocks.

Additionally, utilities are generally capital-intensive businesses that must spend regularly to maintain and grow their power generation systems. In a higher interest rate environment, raising additional equity capital becomes expensive, especially in the renewable energy sector, which is particularly capital-intensive as it builds out infrastructure for this emerging segment of the energy value chain.

Another big headwind facing utilities right now is the potential for shrinking profit margins. With inflation being high for quite some time, the cost of living is growing. In business-unfriendly jurisdictions such as California, utility efforts to pass on increased interest rates and operating costs to consumers through base rate cases are becoming more challenging. This could further reduce profit margins and make it harder for utilities to generate attractive profitability from their operations.

Utilities Enjoy Massive Long-Term Tailwinds

That being said, there are some very real tailwinds for the utility sector. One of these is that it is likely that short-term interest rates are at their peak. The Federal Reserve has signaled that while the exact timing of their next cut is uncertain, their next move is much more likely to be a cut than a hike, which would likely benefit utilities. Additionally, inflation, while perceived to be sticky, is likely at or near its peak and is expected to head lower due to economic indicators such as recessions in several major economies, surplus production in China, rising consumer debt in the United States, the depletion of COVID-era savings, a weakening labor market, and – in some cases – gradually lowering inflation data.

Another significant tailwind is the influx of trillions of dollars into the infrastructure sector. Major institutional investors and billionaires, including Warren Buffett’s Berkshire Hathaway (BRK.A, BRK.B), BlackRock (BLK), Blackstone (BX), Brookfield (BN, BAM), Enbridge (ENB), and many others are investing aggressively in the sector due to the growing demand for stable investments to fund retirements, the urgent need for infrastructure development in developing economies, and the dramatically increasing demand for electricity due to the Fourth Industrial Revolution and the AI boom in developed economies.

Efforts to cut carbon emissions and the electrification of the economy are also fueling aggressive investments in renewable power generation. For example, Microsoft (MSFT) recently signed a $10 billion deal with Brookfield Renewable (BEP, BEPC) to provide green energy to help fuel their AI push. The Federal Energy Regulatory Commission (FERC) has also signaled that it will be easier for large renewable energy projects to get approval, recently approving two new rules that should benefit renewable energy developments. As a result, the utility sector has a bright future ahead of it if it can navigate the current higher capital costs.

What Is The Best Way To Invest In Utilities?

Given that XLU’s top holdings include quality utilities with strong balance sheets such as NextEra Energy (NEE), Southern Co. (SO), and Duke Energy (DUK), it is pretty well positioned to weather the current higher-for-longer environment, even if their growth takes a temporary hit. That being said, while XLU’s 0.09% expense ratio is quite attractive, its 3.01% trailing 12-month dividend yield is not very appealing for income-oriented investors. As a result, we are personally investing in individual utilities that have 5%+ dividend yields along with attractive long-term growth prospects, such as Brookfield Infrastructure (BIP, BIPC) and Canadian Utilities (OTCPK:CDUAF) through its cheaper proxy ATCO (OTCPK:ACLLF). This gives us superior current income and better long-term risk-adjusted total returns compared to XLU through this method.

That being said, for investors who want simple diversification and complete passivity, XLU is a decent option, especially if minimizing asset management fees is a priority over current income. Those who care more about current income and are willing to take on a bit more risk with some leverage might consider funds like the Reaves Utility Income Trust (UTG) and the Cohen & Steers Infrastructure Fund (UTF), which provide easy diversification and passive exposure to the sector while employing active management and strategic leverage to boost current income yield.

Investor Takeaway

Prominent leading institutional investors are pouring trillions of dollars into the utility sector in the face of severe short-term headwinds due to the very attractive long-term tailwinds for the sector. For retail investors who want to invest alongside them in pursuit of this thesis, XLU is arguably the best choice if passive and diversified exposure at a low cost is your priority. If you would like to maximize current income while still taking a relatively passive and diversified approach, UTG and UTF are good choices.

Finally, if like us, you do not mind actively managing your portfolio in exchange for higher current yield and the potential for outsized long-term total returns, picking individual utilities that are the most opportunistically priced currently is the best approach. Regardless of which approach you take, we think that buying utilities today – including XLU – will deliver attractive long-term risk-adjusted total returns.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.