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A Guide to Utility ETFs and Mutual Funds

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Utility mutual funds can be an effective way to diversify your portfolio.

Utility funds are designed to target the utilities sector of the stock market. You can invest in traditional mutual funds or choose utility exchange-traded funds (ETFs) instead. Both have their pros and cons when constructing a diversified portfolio. If you’re unfamiliar with what the utilities sector covers, this guide explains how the various utility funds work and how to invest in them.

What Are Utility Funds?

To understand utility funds, it’s helpful to know what the utilities sector represents. Broadly speaking, it refers to companies that provide utility services relating to:

  • Water and sewage
  • Electricity
  • Communications
  • Natural gas utilities
  • Crude oil
  • Solar energy
  • Dam construction and hydroelectric energy
  • Wind energy

In other words, utilities are the public services everyday people rely on to maintain their homes. Utility funds and ETFs invest in companies that provide utility services to cities and towns or to other entities that distribute power and water services locally.

These funds typically have one of two objectives: capital appreciation or income. Capital appreciation means the fund’s goal is increasing share prices to deliver higher returns to investors. Income utility funds, on the other hand, primarily focus on delivering income to investors in the form of dividend payouts. Utility funds and ETFs that pay dividend income tend to be better suited to a long-term investment strategy while growth-focused funds may work better for delivering near-term gains.

Some utility funds follow an index strategy, meaning they attempt to match the performance of an underlying benchmark or index. An index fund tends to be passively managed, whereas traditional utility funds or ETFs can either be actively or passively managed. Active management means there’s a fund manager making decisions about what to hold in the fund, with the end goal of beating a particular benchmark or index.

Why Invest in Utility Funds?

Utilities can be promising for investors in more ways than one.

First, investing in utility funds is a way to diversify your portfolio it lacks exposure to the utilities sector. With so many utility funds to choose from, you can tailor your portfolio to focus more on renewable versus non-renewable energy if that’s your preference or zero in on a specific sub-category, such as water services. More diversification makes it easier to manage and balance risk.

Next, utility funds that pay dividends can provide steady and reliable income for investors. If you’re in the 10-year countdown to retirement or you’re already retired, having a consistent source of income from your investments can help to shore up your retirement budget. The dividend yields from utility funds, which typically range between 1% and 3%, can outstrip the returns you might earn with bonds, CDs or a savings account.

Utility funds can also be attractive during a recession or periods of economic decline, since demand for these services tends to hold steady. While consumers may cut back on dining out or shopping when the economy slows, they still need to heat their homes, run the lights and have running water. Utility companies that provide these services may have an easier time maintaining profit margins in leaner times, compared to companies in other stock market sectors.

In terms of performance, utility funds can hold their ground against stocks representing other sectors. According to Morningstar, the five-year return for utility funds approaches 10% on average. That’s comparable to the historical average return of 10% associated with the S&P 500, an index of the 500 largest U.S. corporations.

Utility funds and ETFs also offer liquidity to investors, since these funds can be bought and sold easily within an online brokerage account or a tax-advantaged retirement account. That may be important to you if you’re looking to add new funds to your portfolio but don’t want to feel locked in with the money you invest.

Potential Risks of Investing in Utility Funds

Utilities are a key part of the U.S. economy and often a valuable component of a diversified portfolio.

Utility funds do have some risk factors to keep in mind before you invest. For instance, it can be difficult for utility companies to moderate the impact of energy price increases on returns for investors. If operating costs increase or the utility company’s debt load gets too high, then the result could be a cut in the dividend payout to investors.

Traditional utility companies also face increasing competition from renewable energy providers. As more green companies move into the energy space, traditional energy providers may see less demand for their services, which could lead to reduced profits and again, lower dividends for investors.

Utility stocks also face limitations when it comes to growth. A company like Amazon (AMZN) or Apple (AAPL), for instance, can introduce new products or services to attract customers and grow revenues. A utility company, on the other hand, may have less room to expand its services if it’s limited to a particular geographic area or line of service.

How to Invest in Utility Funds

Adding utility funds to your portfolio can be as simple as buying shares of a fund or ETF through your taxable brokerage account or IRA. The hard part is deciding which utility fund or ETF you want to buy.

When you’re comparing utility funds, you’ll want to look at:

  • Which utility companies the fund invests in
  • Historical performance
  • Expense ratio and other fund costs
  • Number of holdings in the fund
  • Whether you’re investing in a mutual fund, index fund or ETF

Just remember that if you already have exposure to utility funds through a broad index fund it may be redundant to add a utility fund.

You’ll also want to check out a utility fund’s dividend yield, but it’s important to not develop tunnel vision where that’s concerned. Dividend yield represents the annual rate of return from dividends to investors. When weighing the current dividend yield, remember to look at a utility fund’s history. Has the dividend yield increased over time, remained the same from year to year or have there been ups and downs? And is the current dividend yield sustainable, based on the profitability and debt profiles of the underlying companies in the fund?

Taking a closer look can help you decide whether a utility fund or ETF will have staying power in your portfolio. Has it been through both a bear and a bull market? If not it may be more difficult to gauge how it will perform when the cycle shifts. Also, keep in mind that ETFs may be a better fit for a taxable account, since these funds are often more tax-efficient than a traditional mutual fund or index fund.

Bottom Line

Utility funds can help you shore up the defensive part of your portfolio if you’re worried about a recession or increasing inflation putting a damper on your investment performance. While utility funds may not experience huge price increases compared to funds representing other sectors, they can offer reliable dividend income, which may serve you well as you prepare for or go through retirement. Researching various utility funds can help you find the one that’s right for you and your investment goals.

Tips for Investing
  • Many online brokerages offer the opportunity to invest in utilities through mutual funds and ETFs, often at low cost. Check out our list of the top online brokerages to get started.
  • It’s a good idea to work with a financial advisor who can help you understand the role that utility funds can play in your portfolio. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.

Photo credit: iStock.com/AvigatorPhotographer, iStock.com/alexsl, iStock.com/CharlieChesvick

The post A Guide to Utility ETFs and Mutual Funds appeared first on SmartAsset Blog.

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