Active Outperforms In Utilities

Active management and utilities investing isn’t a particularly intuitive pairing. And yet, in a sector dominated by index strategies linked to the S&P 500’s utilities sector, Reaves Asset Management is pitching the idea that there’s more driving the utilities sector than simply the price of power.

Its fund, the Reaves Utilities ETF (UTES), which is two years old this month, offers a different, more concentrated focus that seems to be working when it comes to delivering outperformance. Jay Rhame, portfolio manager at Reaves, gives us the rundown.

ETF.com: In 2016, utilities was one of the best-performing sectors. So far in 2017, it's doing pretty well, up more than 11%. But many utilities ETFs are facing net outflows this year. Why?

Rhame: It's partially because people are pretty bullish on the stock market overall. Generally, money flows into utilities when people are starting to be defensive, and out of utilities and into the S&P 500 funds, the tech funds, when they’re getting excited about the market.

The fact is that utilities have actually done pretty well—up until recently, they were outperforming the S&P 500 year-to-date. It's one of those weird things where people are having the traditional response to the markets—they’re up, so they take money out of utilities, and put it somewhere else.

But what’s interesting is that even with that, utilities are doing well. It seems utilities are starting to behave in a different way.

ETF.com: What's the main driver of returns in utilities today? Natural gas prices?

Rhame: It's earnings growth. That's part of the reason we’re seeing this switch in behavior I was talking about. Utilities used to be driven by their dividend and dividend yield. But now we're starting to see real long-term growth plans come out for a lot of utilities.

It’s partially due to a shift from a coal-, nuclear- and gas-driven-generation profile to more of a wind-, solar- and batteries-driven one—gas as well. The ability to invest a lot of money into that infrastructure, as well as in transmission projects; some of the gas pipeline projects, which are starting to get easier to get approved with the new administration and the new FERC—all of that’s impacting utilities.

But it's really the market's confidence in the utilities’ ability to grow a little more consistently over time than perhaps in the past. That's really the big driver now of returns.

ETF.com: Has the new administration played any part in how the market’s perceiving the outlook for utilities?

Rhame: I wouldn't necessarily say it's because of anything the administration has done. The switch to a more renewable-generation profile is happening because wind and solar are becoming economic. A lot of the investment is enabled because gas and power prices are low. And utilities are really able to invest in their infrastructure now when bills are low. That's really the main driver.

The past administration was certainly more positive on renewable development, with tax credits and all that. I don't think we're going to get any more tax credits or anything like that for renewable development, but we're getting close enough to where it doesn't matter anymore.

Costs have come down so much that it's really the economics that are driving it. It's no longer government support or tax policy. As investors realize that it's the economics that are driving the story, and not necessarily government support, these types of stocks have recovered.

ETF.com: Most investors turn to utilities for either safety or income. Should we look at utilities relative to the 10-year Treasury then, and not relative to the broader market?

Rhame: The difference between a utility's yield and the 10-year certainly has been a driver of returns. That’s where we benefit on the active side, because just a straight yield analysis really misses that different utilities have different growth profiles.

A lot of people buy utilities for defense reasons, and they buy it for yield reasons, and they buy it when the yield is X-percent over the 10-year, and that makes sense.

But because of that phenomenon, valuations are actually pretty tight within the industry. The highest-valued utility isn't that much more expensive on a price-to-earnings basis than the lowest-valued utility, even though growth rates are different enough that we've always felt valuations should be more different.

The way we see it, utilities is the only sector where people overpay for yield but underpay for growth. In things like tech or health care, people put huge valuations on any company that can generate growth, and it just doesn't happen in the utility world. That’s where we see opportunity as an active manager.

ETF.com: How do you pick stocks for UTES? In the end, how different is UTES' portfolio from, say, the Utilities Select Sector SPDR Fund (XLU)?

Rhame: First, everything's bottom-up for us. We're trying to buy our best ideas. High growth, good value is the main theme. The biggest difference right now is that we have 22 positions in UTES, while the benchmark—S&P 500 utilities—has around 30 names, so UTES is more concentrated. We have a lot of conviction in our best ideas.

Secondly, given our view that growth is going to be the main driver of returns going forward, we tend to concentrate in utilities that have had the opportunity to do that—grow earnings, grow dividends, grow cash flow. Also, utilities that operate in just one state as opposed to many states generally have more opportunity.

We try to invest in utilities that operate in states that have supportive regulation, and aggressive renewable mandates, or where the people are supportive of renewable spending.

For now, we're avoiding utilities with exposure to the price of power. Our view on the price of power is that natural gas is low, and it's likely to remain low. We have a ton of supply in the country, and natural gas is probably going to continue to be the driver of power prices. So, we don't see much upside for the price of power.

And finally, some of our companies tend to be a little bit smaller than some of the companies in the index as well.

ETF.com: What's the main risk to your approach?

Rhame: Utilities have been on a big run for a while. There's always the risk of a pullback. They're stocks, after all.

Also, if my theory that power prices will stay low is wrong, and solar and wind don't necessarily get as cheap as I think they're going to get, and interest rates go up, we could see bills go up. Power is a full pass-through to the customer.

Your traditional distribution utility doesn't earn money on it; they earn all their money on a return on investment on the infrastructure to support all that. If the price of power goes up, the customer bills go up, but the utility doesn't earn any extra money, then you're starting to worry about earnings growth. Power is the biggest risk.

ETF.com: How does the portfolio yield for UTES compare to that of the S&P benchmark?

Rhame: It's generally lower. There’ve been some times where we've been able to take advantage of a small dislocation, but it’s probably going to be lower. That's because of our focus on utilities that can grow more. They tend to have a little lower yield than some of the other ones.

ETF.com: Are you happy with the performance—UTES is up about 3 percentage points above XLU year-to-date. UTES costs more—0.95% vs. 0.14% for XLU—so is this enough outperformance? 

Chart courtesy of StockCharts.com

Rhame: We're happy with the performance. We're up 16.7% year-to-date. We earned our fee, if you will. We wouldn't have made an active fund if we didn't feel we could outperform.

I think we're actually doing a little bit better than we’d expected because there's not a ton of differentiation between the worst-performing utility and the best-performing utility, so doing 3% better—it's about 6% better since we launched almost two years ago—that’s great.

ETF.com: About half of utilities funds today are all benchmarked to S&P 500 utilities. Do you pitch UTES as a replacement for that approach, or as a complement?

Rhame: A little of both, but we launched it as a replacement for an S&P 500 utilities fund because all the companies we invest in are all regulated, traditional utilities.

Some of the biggest names in the index are very exposed to the price of the power, and we always thought the index was somewhat misrepresentative of the risk someone would expect from buying a traditional utility.

We've tried to develop a product that’s more in line with what one would expect on a risk level. That's showed up in our volatility, our beta. It's been a little bit less volatile than the index so far.

This isn't to say we're always going to stay away from power. It's just more of an acknowledgment that the price of power is volatile. It's one of the most volatile commodities in the world, and the opportunity has to be worth a little bit more to us to take on that excess volatility.

Contact Cinthia Murphy at [email protected]