If you want high dividends right now (and who doesn’t?), but you don’t want to overpay, there’s one place you need to look: utilities.
There are three ways to tap into this sector, but only one hands you the most upside and fattest dividend yields from these unloved cash-spinning companies:
- Buy utility stocks individually
- Buy ETFs specializing in utilities
- Buy closed-end funds (CEFs) specializing in utilities
The third option is the best one. To understand why, we need to go back a few months.
Back on March 1, I recommended Reaves Utility Income, a utility CEF that yields 6.9% (spoiler: those big yields are common with CEFs and are a big reason why these funds are an awesome bet for income investors).
And since March, this fund has soared!
A 7.7% return in four and a half months is impressive for any asset class, but for a “widow and orphan” sector like utilities, it’s unheard of. (The best news? As I’ll show you below, UTG still has plenty of upside ahead.)
So what powered this nice return?
Let’s rewind to early 2018. Energy prices were rising, oil was finally out of its slump and investors were getting nervous about volatility, a trade war and political instability. Utility investors, being more risk-averse than those who focus on most other sectors, sold off.
However, a look at the data made one conclusion unavoidable: utilities’ cash flow was strong, an improving economy meant more energy demand (and thus more income for utilities) and several utilities were far undervalued relative to their book values (or what their assets would fetch if these companies were broken up and sold off).
If you saw this data and ignored the noise from the financial press, you knew there was only one thing to do: buy.
The good news is that it’s not too late for utilities: the sector is only up 1.3% year to date versus the S&P 500’s 5.5%, and because utilities’ earnings are up about 15% from a year ago, this sector is one of the most undervalued in the S&P 500.
Plus, it’s one of the highest yielding, with the benchmark Utilities Select Sector SPDR ETF paying 3.4% dividends, or nearly double the yield on your average S&P 500 stock.
But as I mentioned, UTG yields 6.9%, or twice what XLU pays—which brings me to my No. 1 reason for choosing utility CEFs over ETFs.
CEFs vs. ETFs: A Bigger Income Stream
The first reason to choose CEFs is the most gratifying: the income.
As I mentioned, UTG yields a nice 6.8%, but there are some CEFs yielding even more out there, as you can see from the following chart, which also shows each fund’s discount to net asset value (NAV, or the difference between each fund’s market price and the value of its portfolio), yield on price and long-term compound annual growth rate (CAGR).
Why settle for less than 4% income when you can get 10%?
You might want to answer that the ETFs surely outperform the CEFs, but you’d be wrong—which brings me to reason No. 2 for going with high-yield CEFs over their “dumb” ETF counterparts…
CEFs vs. ETFs, Round 2: Market Outperformance
Think actively managed CEFs must underperform passive ETFs? Think again.
While some utility funds have underperformed XLU over the long term, others have not.
As you can see, UTG, along with three of its peers, has done better than XLU—and not by a little, either. If you had invested $100,000 in UTG a decade ago, you would now have over $260,000, while that same investment in XLU would be worth a hair shy of $191,000.
But how can you spot the winners and avoid the losers? It’s all about the discount to NAV.
CEFs vs. ETFs, Round 3: The Discount Tells the Tale
Most people love CEFs for their large income streams, but the best way to win with these funds is to buy when the discount is huge. Since CEFs’ market prices regularly vary from their NAVs, buying funds when they are at unusually wide discounts and selling when their discounts switch to premiums is a surefire way to make a lot of money fast.
That was why I recommended UTG over the index back in March. Its discount to NAV had sunk to 8.2% after trading at a premium in 2017.
And here’s the good news: UTG’s discount is still where it was when I recommended it, because its NAV has soared in recent weeks, but the market is still pessimistic on utilities!
This means that despite the fund’s 7.7% gains since March, the market is still underpricing it. Hard to believe, but true. This is why you should consider jumping into this fund before the sale ends.
And make no mistake: as soon as the market remembers utilities’ great ability to generate cash (and it will), this sale will end … and fast.
Disclosure: none
