Population Growth Exposure Key To Utility ETFs

Rowland Wilhelm is vice president of Reaves Asset Management based in Jersey City, New Jersey, which is the ETF issuer for the Reaves Utilities ETF (UTES), an actively managed fund that focuses on the utility sector. ETF.com caught up with him to discuss the space and some of the key fundamentals that his firm uses when selecting stocks for the fund.
 

ETF.com: Utilities were one of the best-performing sectors of 2016—at least for the first half. Was it just the idea of safety, or was it an idea of income?

Rowland Wilhelm: It was a big safety trait. And then again, the number of baby boomers who are retiring on a daily basis are all looking for income. Other dividend sectors did pretty well, too. But the utilities sector was clearly No. 1. Having the Fed say it was going to raise rates four times last year, and actually doing it once, was another tail wind to the utility space. That was pretty much through early July, and then it just tailed off.

ETF.com: Why was that?

Wilhelm: A lot of that had to do with some better economic signals, a more hawkish Fed, and just the fact that the tea leaves were pointing to better economic statistics here in the U.S. The Fed funds rate went from about 1.7% to 2.5% fairly quickly, and then it really ramped up after Trump won. It's come down since. The 10-year Treasury is what you really should look at utilities against.

ETF.com: If utilities are a safe play, why would somebody leave that?

Wilhelm: Part of it is just trend-following. Next time you see rates go up, you'll see utilities take it on the chin for a short period of time. A lot of trend followers will leave and look for the next best thing.

You had a long bull market in bonds. People worried about that. Bonds have been uncompetitive compared to utilities for a long period of time now. The average utility that we can find is growing its earnings 5% and growing its dividend around 5% annually. That's not a bad total return starting from a 3% yield.

There really is no Trump trade in the utility space. Corporate taxes aren't going to affect utilities. It's all pass-through. We see that's going to be great for energy companies, great for other sectors we follow—rails, broadband infrastructure.

But that's not the utility story. Nothing really in our mind has changed since Trump got on. Maybe he has some very good pro-growth policies that come through and we'll have more inflationary pressures and consequently more interest rate pressures. But it's not there yet.

ETF.com: Let’s talk about your ETF, the Reaves Utilities ETF (UTES). It’s actively managed. How do you manage it and select securities for it?

Wilhelm: We use fundamental research to come up with the best-ideas portfolio. When we were developing this, we looked at the market. There's roughly $15 billion in passive [utility-related] product out there. Almost half of it is benchmarked to the S&P 500 utilities.

Also, there's about $25 billion in open-end product out there that charges a lot more than we do—95 basis points. A lot of that is slave to the S&P 500 utilities, and in our view, that’s not a great index. If you look at a lot of the exposures, you have Rust Belt exposures. True utility growth right now is coastal, such as NextEra Energy; California utilities; Portland, Oregon. That's where the growth is, and that's where we think you'll get better risk-adjusted returns than the standard index.

ETF.com: And when you say “growth,” is that directly correlated to population growth?

Wilhelm: Yes. You're not getting a lot of growth out of the Midwest right now. It just isn't there.

ETF.com: Is your fund domestic?

Wilhelm: Right now it’s domestic. We do have the ability to go overseas, subject to ’40 Act regulations. Currently there are no ADRs [American depositary receipts] in there. But we could buy a company like National Grid, which is headquartered in the U.K., but 50% of their operations are over here.

ETF.com: So for a utility business, the fundamentals there are obviously demand and energy costs, right?

Wilhelm: A lot of it has to do with cost, because demand has not grown.

ETF.com: Natural gas is the chief energy source for utilities, isn't it?

Wilhelm: It's pretty much the price-setter.

ETF.com: Does natural gas have a predictable price cycle?

Wilhelm: It's tough to predict. You have to watch things like rig counts, where those rigs are. The rig count in the U.S. at the height before OPEC’s and Saudis' moves in 2014 was roughly 1,500 land-based rigs. It then fell to mid-300s. And now we're bucking probably just a little north of 500. But they're really in two basins—Permian Basin, and Marcellus and Utica, the lowest-cost basins.

But tracking the volatility of it is tough. Natural gas used to be coupled with WTI crude oil, for instance. You could almost consider a factor of 10. If gas is at five, crude was going to be at roughly 50.

But they decoupled, largely due to the U.S. shale revolution that pushed a lot of product onto market. Prices went from $14 down to $2. That’s a big collapse. And that hurt utilities—like Exelon, Entergy—who are big suppliers of nuclear power typically at spot prices. Their margins just got destroyed. They went from the lowest cost—and they're still very low cost in production—but natural gas became a better play.

ETF.com: How many holdings do you have in UTES?

Wilhelm: There are about 20 holdings right now, plus or minus one. And there’s no rebalance. We have probably added four positions since inception, and eliminated one or two.

If we're buying a stock, we want to hold on to it for a long period of time, typically two to three years. I suspect our turnover may be lower than the XLUs [Utilities Select Sector SPDR Fund (XLU)] of the world, because they're constantly rebalancing. We can buy and hold.

ETF.com: And in terms of where utilities fit in a portfolio, what are your thoughts on that in terms of asset allocation?

Wilhelm: In the equity sleeve, we tend to see about a 5-10% allocation to the utility space. We think we've designed a product that's your sleeping money. It's going to give you dividends that you can use for reinvestment in the dividend space, or some other riskier part of your portfolio that you want. And it should lower the risk attributes such as your standard deviation, and improve your downside capture.

The problem with utility investments is that it's undercovered on Wall Street in general. You never see a strategist at the beginning of the year saying, “Buy utilities.” That's a very bearish signal. Everyone thinks they're the same, so why spend your time doing it? Southern Company doesn't look like Duke, doesn't look like Scana, their neighbors, let alone look like a California utility. There are nuances there.

Contact Drew Voros at [email protected]