The Best Way to Invest in Utilities

Some investors believe in using only ETFs to construct a portfolio, others just use closed-end funds; others still only use one other type of product at the exclusion of the others.

This makes no sense to me. In constructing a portfolio, you should seek out what you think is the best product for any particular segment of the market.

All products have strengths and weaknesses or are well-suited for one segment and ill-suited for another.

A case in point is in the utility sector. As you might expect, during a market correction (and some people may take issue with my use of the word 'correction'), the utility sector is often a good place to hide out, and that has been the case on this go-round. The stocks tend to have higher yields, lower volatility and stable companies behind them.

But closed-end funds aren't the best way to access this sector. During stock-market panics, the discounts on their share prices to net-assets value tend to widen as investors head for the exits.

The (UTG Quote)Reaves Utility Income Trust (UTG), which listed in February 2004, is a good example. You can see that on the chart below comparing iShares DJ Utilities (IDU Quote), the market price for the Reaves fund (UTG Quote) and the NAV for the Reaves fund (XUTGX). The closed-end fund's market price moved down a lot more than the NAV and the sector, as measured by IDU.

This article is not meant to criticize the people managing UTG. It is an actively managed portfolio, and it makes sense to think that it will sometimes do better than an index like IDU and lag it at other times.

In fact, UTG offers a little more yield than many of the utility ETFs. UTG yields 5.31%, compared to 2.39% for IDU. That offsets some of effect of the widening discount captured in the following chart.

Nevertheless, the chart illustrates why closed-end funds aren't the best vehicles for capturing the stability and low volatility offered by utilities stocks. In effect, UTG's discount to NAV has neutralized several hundred basis points of that benefit to a diversified portfolio at precisely the time when it was most needed.

No Haven In A Storm Reaves Utility Income Trust's share price has fallen faster than its NAV.

Click here for larger image.

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