It has not been a good year for utility stocks in 2023, with the Vanguard Utilities ETF (VPU -1.14%) down by a tough 18% or so. That proxy for the utilities group, however, includes a lot of stocks, and there is a huge difference in how the individual underlying investments performed.
This is why a basket approach could be the best way to go for most investors.
The problem with utilities
Utilities are often bought for their yield. That's a problem when interest rates are rising. For starters, higher interest rates increase a utility's operating costs. But more to the point for these stocks, higher rates generally mean other income options become increasingly more attractive.
For example, with CDs yielding around 5% or so, investors don't need to take on the risk of owning a stock to get a decent yield. With investors shifting their cash out of utilities, the stocks in general have fallen, increasing yields throughout the sector. At some point, the risk/reward balance will hit an equilibrium for investors and the drawdown will stop.
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It is impossible to predict when that point will be reached, of course. And if interest rates keep moving higher, the shift out of the sector will likely continue.
But what's really interesting to see here is the differences underneath the broader index. For example, The Southern Company (SO -1.56%), one of the largest utilities in the United States, has seen its shares fall only around 8% in 2023. By comparison, NextEra Energy (NEE -1.36%) share prices have collapsed by 37%!
The difference here is that NextEra Energy was a Wall Street darling thanks to its large investments in clean energy. Thus, it was bid up to a high valuation. When the mood changed, it was one of the hardest-hit stocks.
Southern, by contrast, has long been a slow and steady tortoise. It has actually been out of favor for a number of years because of a large capital investment that hasn't been going very well. Given that this investment is nearly complete, however, there's actually some good news to counteract the broader negatives in the utility sector.
Taking a balanced approach
The big takeaway here is that diversification matters. Picking a single utility and going all in on that stock is probably a mistake. Imagine how you would feel if you had purchased NextEra at the start of the year. If, however, you had added both NextEra and Southern, your portfolio would still be suffering, but not nearly as much.
These are just two companies used in cherry-picking after the fact, but you get the idea. If you are going to buy a utility focusing aggressively on growth, you might want to pair it with a historically conservative one. The same can be said in just about any sector.
But there's another option here, and that's simply to punt from day one. You don't need to buy individual stocks at all; you can buy an exchange-traded fund like the Vanguard Utilities ETF. Or if you prefer active management, there are plenty of utility-focused mutual funds out there.
The point is that you buy one investment and instantly have a diversified utility portfolio. And yet there are some limitations to this approach to keep in mind.
For example, you can't fine-tune a pooled portfolio to your needs. If you are looking to maximize passive income, you might favor higher-yielding utilities as you build out your portfolio. That's not likely to take place in a sector-specific ETF or mutual fund since they will need more than a handful of stocks to invest all of the assets they manage.
There's also no option to sell losers to capture losses since you don't own the individual stocks inside the ETF or mutual fund. You could do that in your own portfolio, potentially offsetting gains elsewhere, if you bought a few utility stocks directly.
The long and short term
All of that said, it is worth noting that NextEra has been a very good long-term investment despite the current drawdown. So it might make sense for investors who own it to sit tight and focus on the long-term opportunity that still exists in the clean energy space. But perhaps, given the steep decline, you might add a broadly diversified utility ETF or even a less exciting utility stock or two to your portfolio to balance out the risk.
