Utility & REIT Funds Come Roaring Back

The popular equity income plays have turned in excellent 2014 performance so far but remain sensitive to interest rate hikes.

Senior ETF Specialist
Reviewed by: Paul Britt
Edited by: Paul Britt

The popular equity income plays have turned in excellent 2014 performance so far but remain sensitive to interest rate hikes.

History doesn’t repeat itself, but it often rhymes, as the saying goes.

That’s the dark cloud hovering over rosy performance numbers delivered recently by two popular income plays.

Both utilities and REITs provided excellent performance in the first half of 2014 following rocky third and fourth quarters of 2013. The Utilities Select Sector SPDR Fund (XLU | A-92) led the pack of SPDR sector ETFs as the table below shows:

6 mo Sector Rtns

REITs don’t fit neatly into the “select sector” list because they’re a subset of financials. Still, REITs turned in solid first-half 2014 performance of their own, as reflected in the 17.7 percent total return from the largest REIT ETF, the Vanguard REIT ETF (VNQ | A-88).

Utilities and REITs hold appeal as income producers, with yields of 3.69 percent and 3.44 percent for VNQ and XLU, respectively, over the past 12 months, beating that of the broad market proxy SPDR S&P 500 ETF (SPY | A-98).

yield & rtn table

Indeed, it’s the income component of their return that goes a long way toward explaining their recent rags-to-riches performance. The sectors’ steady cash flows helped them look more bondlike to investors, and midway through 2013, investors sold off as interest rates spiked. Uncertainty about Federal Reserve policy kept returns uneven through December.

But in 2014 to date, higher interest rates haven’t materialized. On the contrary, rates have dipped or held steady as the massive stimulus from central banks outside the U.S. has kept Treasury demand high despite tapered purchases from the Fed.


Deja Vu All Over Again

The sensitivity of utilities and REITs to interest rates isn’t a new story. My point here is simply that the risk that played out late last year hasn’t gone away. [For more see our U.S. Utilities and U.S. Real Estate segment reports.]

One way to see this is by looking at correlations of two leading ETFs to that of a broad fixed-income proxy, the iShares Core U.S. Aggregate Bond ETF (AGG | A-97).

To be sure, utilities and REITs, as represented by XLU and VNQ, have been uncorrelated with AGG over the past three years, as shown by correlation of -0.14 and -016, respectively. (Correlations close to zero, like these, mean uncorrelated.)

However, correlations change. The chart below shows rolling six-month correlations with AGG for XLU, VNQ and equity market proxy SPY. Higher correlations here mean that returns for the utility and REIT ETFs are falling when rates rise (I’m comparing with AGG’s returns rather than yields).


The chart says two things. First, correlations with fixed income are volatile for the utility and REIT sectors and for broad equities, with a dramatic spike midyear 2013. Second, both utilities and REITs have been much more sensitive to interest rates than have broad equities.

The takeaway here is simple: Utilities and REITs may founder again on the fear—or the reality—of another interest-rate shock.


Power Plant Vs Office Tower

I lumped utilities and REITs together due to their similar returns and correlations to fixed income over the past 12 months. Yet other performance aspects differ, supporting the traditional role of utilities as a defensive play. Volatility—a stand-alone measure of risk—over the past three years is much lower for utilities than for REITs. Utilities also have the edge on diversification in your portfolio than REITs based on three-year correlations to equity.

table 3 yr Vol & Corr

And for income investors in taxable accounts, the cash flows from REIT ETFs are taxed at the higher ordinary income rate rather than as qualified dividends, as is the case for utilities. That’s due to the pass-through nature of REITs’ legal structure.

Interest rates alone won’t determine the course for these sectors in the near term. Still, as investors continue to fret over the duration in the fixed-income side of their portfolio, recent history shows that interest-rate risk doesn’t stop at the fixed-income edge of the asset allocation pie chart.

The flip side is that the great performance by utilities and REITs seen in the first part of 2014 may have further to run. The low-rate environment lingers on, inflation remains low and equity markets have taken tapering in stride.

Income plays remain attractive even from a total-return perspective as prospects for growth remain uncertain. In short, utilities and REITs may well continue on their merry path through the rest of 2014. Just know that investors may again head for the exits if rates rise, bringing prices down with them.

At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at [email protected] or follow him on Twitter @PaulBritt_ETF.


Paul Britt, CFA, is a senior analyst in the ETF Analytics group at FactSet, a team that maintains and develops an industry-leading suite of ETF-related data and analytics products. Prior to joining FactSet in April 2015, he was a senior analyst at etf.com, where he performed a similar role, and worked in private placement at Pensco Trust. Paul holds a B.S. from RIT and an M.S. in financial analysis from the University of San Francisco.