The ETF Effect

Morningstar (NSDQ: MORN) recently reported that 247 mutual funds suffered outflows of at least 10 percent over the past year, with 18 losing more than 40 percent of their assets under management. Redemptions on this scale usually occur toward the end of a bear market, when many investors throw in the towel.

This hemorrhaging stems from the growing belief that passive investment strategies involving exchange-traded funds (ETF) will outperform an active management over the long haul. Lower fees also help to bolster overall returns.

Of course, ETFs and other products that offer one-stop exposure to a particular sector or theme often weight their positions by market capitalization. Utilities Select Sector SPDR (NYSE: XLU), for example, rebalances its holdings quarterly and exhibits a bias toward stocks that have already run up.

At last check, NextEra Energy (NYSE: NEE), which trades at a record 21 times trailing earnings, accounted for 9 percent of the ETF’s portfolio. And the instant diversification offered by ETFs mean that you’ll always own the good, the bad and the ugly, which dilutes the best performers’ contribution.

But discriminating investors can take advantage of the rise of ETFs.

Exchange-traded funds make it easier for investors to hedge their portfolios or take advantage of short-term opportunities. In previous years, we’ve used ProShares Ultra Utilities (NYSE: UPW), an ETF that delivers two times the Dow Jones US Utilities Index’s daily performance, to take advantage of the sector’s seasonal strength in the fourth-quarter.

Meanwhile, ProShares UltraShort Utilities (NYSE: SDP), which is designed to post two times the inverse daily return of the Dow Jones US Utilities Index, gives investors a convenient vehicle to hedge their exposure to utility stocks when the sector runs up to frothy levels.

With most ETFs employing a capitalization-weighted approach to portfolio construction, the sector’s biggest names will experience sharper upswings and downswings. Buying Utilities Select Sector SPDR, for instance, amounts to a program trade to buy the underlying stocks. Selling the ETF has the opposite effect.

Nimble investors who trim their individual positions when valuations become frothy and reload on the next downswing can bolster their overall returns. And investors who own high-quality, dividend-paying names needn’t concern themselves with ETF-driven volatility.

Finally, bigger upswings and downswings create an opportunity for companies to issue debt and equity when momentum pushes valuations to elevated levels. Dominion Resources (NYSE: D) has taken advantage of this volatility to sell additional shares.

With first-quarter earnings season around the corner, this month’s update to the Utility Report Card reassesses the 214 essential-service companies in our coverage universe through the lens of our proprietary Quality Grading system.

Here’s a rundown of this month’s featured ideas: