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VUIAX: This Utility Mutual Fund Is Keeping The Lights On

Summary VUIAX has a respectably low correlation to SPY, but the correlation and relative volatility have changed materially over time. The expense ratio is great for an investor wanting some cheap diversification throughout the utility sector. I expect the Federal Reserve to push hard for raising rates in December, but I don’t think rate increases can be sustained. Utilities are sensitive to interest rates, so an increase in rates would trigger lower prices and a buying opportunity. In my past analysis on other utility mutual funds and ETFs I have found they can offer some nice benefits to the portfolio from lower levels of volatility and lower levels of correlation to the S&P 500. However, finding a good utility mutual fund can be a problem because a high expense ratio can destroy a fund that would otherwise be very attractive. Since the Vanguard Utilities Index Fund (MUTF: VUIAX ) has an expense ratio of only .12%, I’m feeling pretty optimistic going into this one. Does VUIAX provide diversification benefits to a portfolio? Each investor may hold a different portfolio, but I use the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) as the basis for my analysis. When I ran a regression on SPY and VUIAX, I found a correlation of 78%. That isn’t very low, but it is not high enough to be problematic. I found the annualized volatility for VUIAX was 18% since February of 2004, which was slightly lower than the overall market at 19.4% during that time span. However, if an investor focuses only on the last couple of years the resulting volatility levels are significantly less favorable for VUIAX. Over the last 24 months the annualized volatility on VUIAX was 14.8% and it was only 13.1% on SPY. On the other hand, during those 24 months the correlation was only around 53% rather than the longer term average of 78%. Expense Ratio The mutual fund is posting .12% for an expense ratio. What else is there to say? That is a solid expense ratio. Largest Holdings The diversification within the mutual fund is pretty weak. For a very long term holder it might make sense to replicate the mutual fund by just buying the underlying securities and taking higher trading costs to eliminate the expense ratio. However, an expense ratio of only .12% would be difficult to beat without a fairly long time horizon or a large volume of commission free trades in the account. (click to enlarge) The major holdings here are the same ones I would expect to see. Duke Energy Corporation (NYSE: DUK ) is a fairly huge utility company and frequently at the top of the list for utility mutual funds. All around this appears to be a reasonable portfolio for an investor that wants to get more utility companies into their portfolio without having to buy the companies individually. Why Utilities Investors may be wondering why they should look to raise the utility allocation when the Federal Reserve is talking about raising rates. Since utilities tend to have some material correlation to corporate bond funds, it would seem like an allocation to utilities would be dangerous. When it comes to the Federal Reserve, my stance is that they can’t raise rates as rapidly as they would like to raise them. Because I expect them to substantially underperform their projected trajectory, I see the December meeting as potentially providing a great entry point for equity REITs, utilities, and bonds. I see the potential for weaker prices as being indicative of solid entry points, it simply requires having the conviction to pull the trigger right when everyone else is bracing for higher rates. Conclusion Utility companies can act as a form of income investment because of their strong dividend yields. Unlike buying into a bond portfolio investors can expect that the level of dividends will be increasing over time which makes up for the portfolio having more risk than a simple bond portfolio. When it comes down to designing an ideal portfolio, I think there is a viable argument for running a higher allocation to the utility sector as a way to improve diversification throughout the portfolio. The biggest weakness for using utility companies as a way to diversify the portfolio is that the diversification benefits of the utility allocation are not as strong as the benefits from simply using a diversified bond portfolio since bonds have historically shown materially lower correlations with the S&P 500. If an investor already has a large allocation to bonds, the benefits of adding VUIAX will not be as strong. On the other hand, if an investor places a high value on getting qualified dividends as a source of income, it would materially increase the relative attractiveness of VUIAX. In those cases, it would make sense to use a stronger allocation to VUIAX to reduce portfolio risk.

SCHX: Low Fees Just Got Lower And The Portfolio Is Still Great

Summary SCHX is a leader among low fee ETFs. This balanced portfolio works great as a core holding. The fund holds most of the major companies in the domestic market, so diversification should focus on bonds, international exposure, and REITs. One of my favorite funds that is not currently in my portfolio is the U.S. Large-Cap ETF (NYSEARCA: SCHX ). This fund offers investors exposure to the domestic equity market and has a rock bottom exposure of .04%. Or at least, I used to think .04% was the lowest investors would find on domestic equity. It turns out Schwab is in a pricing battle with BlackRock’s (NYSE: BLK ) iShares products and will be lowering the expense ratio from .04% to .03%. What does SCHX do? SCHX attempts to track the total return of the Dow Jones U.S. Large-Cap Total Stock Market Index. At least 90% of funds are invested in companies that are part of the index. SCHX falls under the category of “Large Blend.” Largest Holdings The portfolio has solid diversification. The SPDR S&P 500 Trust ETF ( SPY) is holding a very similar portfolio but with a slightly larger allocation to the top companies, such as 3.55% in Apple (NASDAQ: AAPL ). However, the additional diversification for SCHX can be partially set off by some of the companies near the top being less volatile or by the ETF having less trading volume. (click to enlarge) Perhaps the question should be why investors would choose options with higher expense ratios when the holdings in SCHX make so much sense. The huge holdings here are established dividend growth champions, which the exception of AAPL and Facebook (NASDAQ: FB ), however I suspect that within 10 years those companies will have a very solid history of raising their dividends. Sector The one thing that concerns me about the way the fund is set up is the relatively light weights given to utilities and to consumer staples. I feel that makes this portfolio a little more aggressive than I prefer to be with the core of my portfolio. (click to enlarge) The reason these sectors are so appealing to me has everything to do with where we are in the macroeconomic sector. We’ve been in a prolonged bull market for quite a while and the valuations have started to get fairly rich. The Federal Reserve has given clear signs that they are desperate to raise rates, but I don’t foresee them being able to raise rates more than once or twice because the international rates are so low. If the Federal Reserve does manage to raise rates, I would be concerned about it creating headwinds for the domestic equity market and the possibility of establishing a new recession. To guard against that risk without having to sell out of the market, I prefer to increase the allocation to the more defensive sectors. Utilities benefit from functioning as regulated monopolies which allows them to expect to earn a fairly steady rate of return. Their prices do move up and down with bonds which would make higher bond yields suggest that utility prices might go down, but the utilities also offer dividend yields that are often superior to the bond yields and they benefit from increasing dividends in most years. That creates a very compelling risk/reward proposition and gives investors a solid reason to favor adding a utility allocation to their portfolio when using SCHX as the core. Consumer staples benefits from having established positions and selling products that consumers buy in good times and bad times. For instance, the tobacco industry has been a great source of returns for the consumer staples sector and continues to create sales regardless of what is happening in the market. My estimates on reasonable allocations for consumer staples and utilities for a highly risk-averse investor would be running as high as 40% of the domestic equity position. Since these sectors only give us 9.1% and 3.0%, that would require investors to specifically add exposure to the portfolio. Meanwhile they could use a fund like SCHX for another 40% of the domestic equity allocation. I would want the remaining 20% of the domestic position for REITs. Investors looking for an easy way to invest in the consumer staples sector may want to consider the Vanguard Consumer Staples ETF (NYSEARCA: VDC ) as a solid partner for working with SCHX in a portfolio. For utilities, I would suggest the Vanguard Utilities ETF (NYSEARCA: VPU ). Conclusion SCHX is a very strong contender to be a core holding in the new portfolio. I wanted a replacement for SPY that I would be able to trade without commissions. Of course, I also wanted to see a lower expense ratio, and SCHX delivered that. I like the idea of combining a large cap fund like this with domestic positions in consumer staples and utilities to create a more defensive weighting since the market has been in a prolonged bull period and the price/earnings ratios have become fairly rich. Prices have dipped back down since late summer, but now investors are facing the possibility of weaker earnings in 2016 which could offset the reduction in price.