Cheap Utility Funds That Pay Rich Dividends

NEW YORK ( TheStreet) -- Shares of power producers have been ice-cold lately. Mutual funds that invest in utilities have returned 0.4% this year, lagging the S&P 500 Index by 8 percentage points. The fund group ranks dead last among the 21 domestic equity categories tracked by Morningstar ( MORN).

The slow going can be traced partly to the mood of the market. Since stocks hit bottom in 2009, investors have preferred shaky companies that once seemed about to collapse. Rock-solid electric and gas producers have attracted little interest.

Utilities have also been held back by uncertainty surrounding tax rates. If Congress does nothing, cuts passed under the Bush administration will expire. Dividends will be taxed as ordinary income, and the maximum rate on dividend income will climb from 15% up to 39.1%. That would be a blow to utilities stocks, which are prized for their high dividends.

Should you steer away from utilities? Maybe not. Based on dividend yields, utilities could be attractively priced. Traditionally utilities deliver about 90% of the yield of the 10-year Treasury. But now that utilities share prices have lagged, their yields have become relatively rich. The yield on the Utilities Select Sector SPDR exchange-traded fund ( XLU) is 4.24%, well above the Treasury yield of 3.66%. "Historically you did well if you bought utilities whenever they yielded more than the 10-year Treasury," says John Kohli, portfolio manager of the Franklin Utilities Fund ( FKUTX).

For long-term investors, utilities funds can help diversify portfolios. Supported by the hefty dividend yields, utilities funds tend to hold up in market downturns. When markets collapsed in 2008, many utilities funds outperformed the S&P 500 by wide margins.

Utilities managers follow a variety of strategies. Cautious funds stick with regulated utilities that pay reliable dividends. Aggressive choices buy a range of stocks, including unregulated energy companies and fast-growing cellular businesses.

Among the most conservative funds is the Franklin Utilities Fund. Manager John Kohli focuses on regulated electric and gas utilities. Because of its caution, the fund tends to lag in bull markets, but it excels during downturns. Limiting losses, the fund has returned 7.9% annually during the past 10 years, outdoing 98% of its competitors.

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