Utilities have been underperforming the market lately — down 11% from highs made in November. With the decrease in price,in the Utilities etf (XLU) has increased considerably above the S&P 500 (SPY).
So what’s the reason for the decrease in utilities? We present a couple of ideas:
Sector Rotation — Utilities aren’t sexy and the market has been soaring — Investors have been seeking more attractive alternatives. But with this decline comes potential opportunity since implied volatility has increased.
Underperformance When Interest Rates Rise. The Fed Reserve has increased rates 3 times this year — as rates rise, this applied downward pressure to price to keep dividends similar to higher available interest rates. Additionally, interest rates weigh heavy on Utility’s bottom line — they tend to be heavy on debt. Higher rates mean increasing interest expenses.
3 Ways to Play Utilities.
Cost Reduction — Buy XLU, collect the annualized dividend yield of 4% and sell calls to reduce cost basis
Pairs Trade — Play the divergence of TLT and XLU. Buy XLU; Sell TLT. This can be done using short puts in XLU and short calls in TLT.
Use Synthetics — Construct positions using synthetics to reduce the impact on the cash balance. This means if you want to get long XLU, buy the at-the-money call and sell the at-the-money put. This uses the account’s buying power as opposed to getting charged margin.