Utilities ETFs are easily overlooked. At last count, there are only four of them in Canada — far fewer than what’s required to be a recognized fund category — with combined assets of $2.6 billion.
Utilities ETFs invest in some of the least glamorous companies, such as power producers and distributors, whose revenues and profits are often subject to government regulations. “They have massive fixed assets that really contribute to them having that monopoly-like character,” said Mike Dragosits, portfolio manager with Oakville, Ont.-based Harvest Portfolios Group Inc.
What shouldn’t be overlooked is that utilities, along with sectors that share similar characteristics, are attractive investments for conservative, income-focused investors.
Utilities stocks tend to be less volatile than the broad market while paying higher dividend yields. And over the past 10 years, the utilities sector in Canada generated total returns slightly higher than that of the S&P/TSX Composite index.
Through utilities ETFs, investors can obtain diversified exposure to these defensive holdings without having to buy individual stocks. The Canadian-listed ETFs range from Canadian to North American to global in scope. Two of them write covered-call options to generate additional income.
The purest utilities sector plays are the $493-million BMO Equal Weight Utilities Index ETF and the $301-million iShares S&P/TSX Capped Utilities Index ETF. Both invest exclusively in Canadian utilities stocks, which constitute about 5% of the market capitalization of the broad market. The ETFs have identical management expense ratios (MERs) of 0.61%.
An important advantage of Canadian utilities ETFs for investors in non-registered accounts is full eligibility for dividend tax credits. “For taxable investors,” said Steven Leong, head of ETF product with Toronto-based iShares sponsor BlackRock Asset Management Canada Ltd., “the eligible dividend income stream is attractive from an after-tax perspective relative to, say, interest income from a bond or a GIC.”
A specific allocation to Canadian utilities ETFs can serve to moderate the market’s ups and downs. The correlation coefficient of the BMO ETF is about 0.5 to the broad market, said Chris McHaney, director and portfolio manager, BMO ETFs, with Toronto-based BMO Asset Management Inc. “So it’s a nice diversifier in the portfolio and really brings the overall risk of the portfolio down quite a bit.” (By definition, the broad market has a correlation of 1.0.)
The iShares ETF’s universe consists of utilities stocks as defined by the global industry classification standard methodology. It’s a “precise building block” that investors can use to build a domestic equity portfolio sector by sector without being concerned about overlap, Leong said.
With just 16 holdings, the iShares ETF imposes a cap of 25% on any one name. This isn’t applicable currently since the top holding at the end of June was Fortis Inc., with a 20.3% weight, followed by Brookfield Infrastructure Partners at 15.8%. “There’s a reasonable expectation that the portfolio will be diversified to some degree,” Leong said. “The single security weight limit helps to ensure that that’s achieved.”
Even more diversified by individual security is BMO’s Canadian utilities ETF, which is designed to replicate the performance of the Solactive Equal Weight Canada Utilities Index.
“You’re getting a true exposure to a sector rather than to a couple of stocks,” McHaney said. “If you looked at utilities on a market-cap basis, there’d be three or four stocks that would take up [roughly] half your portfolio.”
The BMO ETF’s tilt toward smaller-capitalization stocks has produced a 9.5% compound annual return over the 10 years ended June 30, compared with the iShares ETF’s 8.4%. At last report, BMO’s annualized distribution yield net of fees was 3.52%, modestly higher than iShares’ 3.21%.
Higher yielding still are the $1.63-billion BMO Covered Call Utilities ETF and the newest entrant, the $127-million Harvest Equal Weight Global Utilities Income ETF. They are actively managed, with MERs slightly higher than the all-Canadian index ETFs: 0.71% for BMO and 0.79% for Harvest.
BMO writes covered calls on about half its portfolio, enabling the ETF to generate an annualized yield of 7.62%. “That strikes a nice balance between generating that income but then still allowing for growth potential for the rest of the portfolio,” McHaney said. He noted that the options premium income that the ETF collects is also tax efficient, since it’s treated as capital gains.
The Harvest ETF writes covered calls on up to 33% of the portfolio, with the percentage varying month to month, depending on how much cash flow the ETF needs to generate its fixed monthly distribution.
Harvest’s stocks yield an average of about 4.1%, but when covered call income is included the distribution yield rises to a current 7.46%, Dragosits said. “So you’re getting a big boost over and above the yield that you’re already seeing from the stocks.”
Neither of the covered-call utilities ETFs is a pure play on utilities stocks, nor the Canadian market. Both also hold telecommunications and pipeline stocks, and invest outside Canada.
“We always knew with the covered-call overlay that we would need significant liquidity in the underlying equities in the portfolio,” McHaney said. “So we added in what we call utility-like sectors.” Also, providing more liquidity and diversification, a third of the portfolio consists of U.S. stocks. A little more than half the BMO portfolio — 55% — is held in the utilities sector.
About 40% of Harvest’s 30-stock large-cap portfolio is in telecom, making it more growth-oriented than a utilities-only mandate. Investing in the U.S., Canada and western Europe, this ETF also has the broadest geographic scope. “We’re helping to diversify away from any potential risk like natural disasters or government politics or even regional regulatory risk,” Dragosits said. “That’s just adding layers of additional diversification.”