Mostly Voices [0:00]

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. If a man does not keep pace with his companions, perhaps it is because he hears a different drummer. A different drummer.

Mostly Mary [0:19]

And now, coming to you from dead center on your dial, welcome to Risk Parity Radio, where we explore alternatives and asset allocations for the do-it-yourself investor. Broadcasting to you now from the comfort of his easy chair, here is your host, Frank Vasquez.

Mostly Uncle Frank [0:37]

Thank you, Mary, and welcome to episode 27 of Risk Parity Radio. Today on Risk Parity Radio, we are going to continue our discussion of utilities and go through an analysis to see whether a fund that specializes in utilities might be something that you want to consider for your risk parity style portfolio. But before we get to that, I wanted to give a little shout out to my friend Diane Merriam, who mentioned us on her podcast today that is Optimal Finance Daily, where they read blog posts from various people in the financial community and she discusses them. and I will link to that in the show notes. You may know Diana from the Economy Conference. She is very active in the financial independence community, and she is also sponsoring a free webinar this Sunday, November 1st, that is called the FI Lexible webinar, and I will also link to that in the show notes. Thank you, Diana. Now what we discussed in that optimal finance daily podcast or what was referenced there has to do with what we call the macro allocation principle. If you want to know more about that, I would suggest you go back and listen to episode seven, which is our three principles that guide our construction of risk parity style portfolios. which I think is actually one of the more important episodes from a big picture perspective. Now turning back to the topic of the day, we will use the 10 Questions to Master Successful Investing from David Stein to analyze utilities sector funds and to see whether that might be a good investment for us. and these are 10 questions. I will link to them in the show notes as well. The first question is, what is it? Now this is a relatively simple answer for this one, since a utility sector fund is a fund that invests in utilities and these utilities are traded on stock markets and you can buy them individually or you can buy them as part of a fund. We all know what utilities are. They supply our electric and gas and other things that we use in our houses and are used in industry to run them on a daily basis. These businesses are regulated, they are very stable, they are natural monopolies, and they tend to pay significant dividends. There are some utilities that do get into trouble occasionally. The one that we can point out today is PG&E. in California, which has had a number of problems and could be facing a bankruptcy, believe it or not, which is rare but is not unheard of in the utility sector. But it also illustrates the risks of buying individual companies. Okay, question two. Is an investment in a utility sector funded investment a speculation or a gamble? Again, this is an easy answer to this question. It is clearly an investment. It is an investment because this is a business that is making money, it is making profits, and it is paying out some of those profits to its shareholders in the form of dividends and other profits are being retained to maintain and grow the business. Although most of these businesses do not grow very quickly. Question three, what is the upside? Well, the upside to investing in a utility is that steady stream of income, which usually comes in the form of dividends. Utilities will appreciate in value as well, and they are often tied to bond interest rates in that utilities are seen as somewhat of a bond proxy. so that when interest rates go down, the price of utilities tends to go up. This is not a linear one-to-one relationship, but it has been observed over time that utilities tend to increase in value when interest rates fall and tend to decrease in value when interest rates rise. Number four, what is the downside? Well, there are a couple of downsides, one being if interest rates do rise, you would expect the share price of utilities to fall even though the income and dividends are likely to remain the same. The other downside to utilities is that they do not tend to grow a lot, so you would not expect to see lots of gains from them that is more in relation to other kinds of stocks. But it's not a terribly large downside because we assume that you already have an allocation of other kinds of stocks in particular in large index funds. Number five, who is on the other side of the trade? Well, utilities are held very broadly by many sectors of the market. They appear in index funds, they appear in low volatility funds, they appear in dividend funds, they are owned heavily by institutions, and they are viewed as a basic staple of investing in the stock market. Now they don't occupy a large portion of the stock market, it's only 2 or 3% if you look at the total capitalization of the stock market overall. But these funds that I mentioned that are low volatility or dividends or anyone interested in value or income investing is likely to be holding or interested in holding lots of utility stocks or a lot more than an average index fund would hold. Now question number six, what is the investment vehicle? Here we are largely talking about exchange traded funds, ETFs, which are the most popular way to buy this sector. The biggest ones out there are XLU, which is the SPDR fund that we've talked about in previous episodes, and that has 12.15 billion dollars invested in it. It is the largest utility sector fund by far. The other choices that are readily available and relatively cheap are VPU, the Vanguard Utilities ETF, and FUTY, which is a Fidelity Utilities Index ETF. And all of those have low expense ratios of less than 0.15%. There is another popular fund called iShares US Utilities ETF, which is ticker symbol IDU. It's from BlackRock, but it does have a much higher expense ratio and a lot less invested in it than that comes in at 0.43%. There are probably about another dozen utilities ETFs that you could invest in. that are more focused. There are also mutual funds that hold utilities, but they're much less popular for this kind of investment. And of course you can buy utilities individually if you would like, but make sure you analyze them if you are going to do that because you don't want to end up with PG&E. Question seven, what does it take to be successful? Well, it takes the same effort as it does to buy any kind of index fund. If you are just going to buy an ETF, pick one that has a low expense ratio such as XLU, VPU, or FUTY and buy it and that's all you really need to do. If you do want to look at utilities more individually, then you're going to have to analyze each company individually and that's going to take a lot more work. in reading financials and other materials to determine whether one is appropriate for you. It's not something we would recommend here on Risk Parity Radio because we are not a stock picking operation. Question number eight, who is getting a cut? Well, there aren't too many cuts being taken out of these if you go with a low expense fund or you buy the utilities individually, the transaction costs are low or non-existent. In days of old, you could buy these things through drips as well, where you would take the dividends and the company itself would reinvest it into the utility. But this is kind of an archaic setup since we're down to no fee trading these days, and there's probably no reason you would need to go to something more complicated like that. I used to recall getting solicitations in the mail from utilities with my utility bill about these programs, but I don't see them anymore. I haven't seen them in quite a long time. And now we get to question nine, which is the most important question today, which is how will a utilities sector fund or an investment in utilities affect or impact our portfolios. Now to do that we need to consider a couple of things. We need to consider the returns that utilities generate and we need to consider the correlations that utilities would have with the rest of our investments. Now utilities typically have a slightly lower return than the stock market overall. but it's relatively consistent with it. And this has been going on for quite a long time. What's more interesting is to look at a correlation matrix to see how it matches up or lines up in terms of diversification with our other investments. And we did an analysis at Portfolio Visualizer that we will link to in the show notes to look at these main utilities funds that we mentioned, which are XLU, VPU, FUTY, and IDU. And we put them in a matrix also with VTSAX, the Total Stock Market fund from Vanguard, TLT, the long-term treasuries, GLD, gold, and VQN, the Vanguard REIT fund, to see if they were correlated or not. And what we see is that utilities tend to have a low but positive correlation with most of these things. And we'll just use XLU as the example because they're all very similar. And you can see from the analysis that XLU has a positive 0.34 correlation with the total stock market. It has a positive 0.29 correlation with these long-term treasury bonds, and it has a positive 0.33 correlation with gold, which is represented by GLD. Interestingly, it has a higher correlation with REITs. And so if you look at the correlation between XLU and VNC, you see it at 0. .68. But still these are decent correlations for consideration in a risk parity style portfolio because they're much less than the 0.6 correlation that Ray Dalio mentions as the sort of cutoff for really getting something that is diversified. So you can see that these can be a useful part of the portfolio, particularly because they seem to occupy a space that is between the total stock market funds or typical growth or value large cap stocks and the long-term treasury bonds which are on the other end of the diversification spectrum. So you see these right in the middle. Now what they are obviously similar to is REITs and you can see that they are positively correlated. with REITs to a greater extent than with the other things in the typical risk parity style portfolio. And so a natural question to ask might be, should we include these as well as REITs in a risk parity style portfolio, or should we include them as a substitution for REITs in a risk parity style portfolio since they seem to be occupying kind of the same space? So to test out how utilities might perform in one of our portfolios, we took a look at adding them or subtracting them from REITs in one of them. But before we did that, we also took a look at the overall returns for REITs and utilities over the past 40 years or so. It is the case that REITs performed extremely well from the period of 1975 through 2006 where they had an annualized return of 16.7% and that was much better than the utilities. We didn't have specific data for utilities going back that far because the utilities funds have really only existed for about the past 20 years. But it's clear that REITs were one of the top performers of all kinds of equities. in that time period. And then what happened to REITs is they had a horrible 2007 and 2008 there. They were still outperforming the general stock market between 1975 and 2014, but really since them have dropped off. So if you compare REITs and utilities over the past, say, 20 years, you would see that utilities have actually outperformed REITs in that time period. A lot of that has to do with the bad period of time for stocks in general between 2000 and 2010 because that was actually a decent period to own utilities with interest rates generally falling. Utilities outperformed most of the other sectors of the stock market during that period. Now this gives us a little warning because we're not sure whether reits or utilities will outperform in the future. All we can be really sure of is that they tend to both have low correlations with the other asset classes that we typically hold in our risk parity style portfolios, but they also tend to have a relatively positive correlation to each other. So another thing we decided to do was to take one of our sample risk parity style portfolios that had REITs in it and swap out the REITs for utilities and just take a look at how that kind of portfolio would have performed, at least for the data that we have for it. And the data does only go back to 2004 for these portfolios. We're going to link to them on our show notes. They come from Portfolio Visualizer and the data sets there. Now we constructed three portfolios and all of these, I should say, are based on the Golden Ratio Portfolio, which is one of our sample portfolios at the www.riskparadioradio.com website. If you look on the portfolios page, you'll see the original one of these. So we constructed three portfolios. One that had 42% stocks, 26% long-term treasury bonds, 16% gold, and 10% utilities represented by XLU and cash of 6%, and then a comparison portfolio, which is really the one that's on the website, which is 42% stocks, 26% long-term treasury, 16% gold, 10% real estate and 6% in cash. And then just to add another dimension, we added portfolio three, which has divided that allocation, that 10% allocation between the two. So that third portfolio has 42% stocks, 26% bonds, Long-term Treasury, 16% gold, 5% utilities fund XLU, and 5% REITs along with the 6% cash. Now taking a look at these three portfolios, we did see that they actually performed fairly similarly over this time period since 2004. The first portfolio with utilities in it had a compounded annual growth rate of 9.17%. the one with the REITs had 9.04% compounded annual growth rate, and the one with both of them was in the middle as you might expect with a compounded annual growth rate of 9.10%. They all had similar best years of slightly over 22%, they all had similar worst years of down 8.7% to down 9.5%. with maximum drawdowns between 19 and 22%, which ends up getting you to sharp ratios that are fairly similar. The utilities version of this did perform the best in this time period. It has a sharp ratio of 0.99. The sharp ratio for the REIT-based version of this is 0.89, and then the mixed one is 0.94. as you might expect, it's right between the other two. So what this is telling us is that at least for this time period, utilities were superior to REITs in this style of a portfolio. But over long periods of time, it appears that they are relatively similar. And just looking at a couple other metrics in this analysis, we see that the volatility for these portfolios is between 2.29% and 2.5% monthly annualized. It's between 7.93% and 8.70% monthly with the utilities being slightly less volatile in these portfolios than the REITs. And if we look at the perpetual withdrawal rates, which is a measure of how much you could take out of it assuming it performed in this period like it does in this period forever and you want to preserve all of your capital it would have been 6.52 for the utilities based portfolio 6.41 for the REIT based portfolio and the 6.47% for the mixed portfolio. So again what this is telling you is that REITs and utilities can perform a similar function within a risk parity style portfolio, and both are probably decent options, at least in small amounts. You would not want to overweight a portfolio with either one of these options. And so we get to question 10, which is, Should I invest? and the answer is a maybe. This is certainly something that you might want to add to a risk parity style portfolio. It does not appear to be a necessity. It is kind of like REITs in that category there. You should also take a look at what you are already invested in because you will find a lot more utilities already in some of the larger funds that you might be invested in. For example, in our sample risk parity style portfolios we have investments in low volatility funds such as USMV and SPLV and those are 6 to 8% utilities which is about three or four times as much devoted to utilities as a total stock market fund. So if you have a fund like that, you may already be getting some additional exposure to utilities and you may not need more exposure to utilities with those. And then if you look at something like a dividend fund, say, VYM, those are also tend to be weighted towards having more utilities in them. So that one is eight or nine percent invested in utilities compared to a total stock market fund, which is about 2 to 3% invested in utilities. So again, that tells you if you already have a tilt towards utilities and some of the funds you already hold, perhaps it is unnecessary to be adding more to that. On the other hand, if you don't have any utilities in your portfolio, perhaps it would be something that you might want to consider. Perhaps if you're stock funds are more allocated towards growth or large cap growth, you might see some additional diversification value to holding something like utilities as a separate holding in your risk parity style portfolio. And then of course there's a separate question that if you decide to add them, there's a question of how much should you put in to your risk parity style portfolio. I would not think that you would want to overweight significantly in utilities simply because they are not going to likely keep up with the rest of the stock market. They don't really have much in the way of growth characteristics so that if you are putting them in there you need to think about where they sort of fit in between your stocks and your bonds. And they are one of those sort of in the middle types of asset classes that are useful to an extent, but not a panacea overall. And if you are going to include them as a separate fund, I would run some analyses to see how they perform in your overall portfolio. Because what's not important is how they perform in a vacuum. What's important is how they perform in relation to and what they add to your overall portfolio. And with that now I see our signal is beginning to fade. If you'd like to contact me you can do so at frank@riskparityradio.com the email is frank@riskparityradio.com or you can go to the website www.riskparityradio.com .com and fill out the little contact form there. We will be continuing next time with our weekly portfolio review, which may be pretty interesting this week because we finally have a seriously down week in markets and the volatility is picking up. So there are more fireworks and we are also at the end of a month and we'll be considering how much to draw down out of each of the sample portfolios next week. Thank you for tuning in. This is Frank Vasquez with Risk Parity Radio, signing off.

Mostly Mary [25:43]

The Risk Parity Radio show is hosted by Frank Vasquez. The content provided is for entertainment and informational purposes only and does not constitute financial, investment, tax, or legal advice. Please consult with your own advisors before taking any actions based on any information you have heard here. making sure to take into account your own personal circumstances.