The "Magnificent Seven" includes Microsoft, Apple, Nvidia, Alphabet, Amazon, Meta Platforms, and Tesla -- seven technology-focused companies that make up over 30% of the market cap of the S&P 500. These companies primarily drove the broader market to new heights. And they were a core reason why exchange-traded funds (ETFs) like the Vanguard S&P 500 Growth ETF (VOOG 2.17%) were generating monster gains.
But a recent sell-off across megacap growth stocks sent the Nasdaq Composite down over 10% from its 52-week high. The sell-off -- paired with some investors shifting toward value stocks -- has made the unassuming Vanguard Utility ETF (VPU 0.87%) the best-performing Vanguard ETF year to date. Here, we'll consider why a stodgy, low-growth sector like utilities is doing well and if the Vanguard Utility ETF is a buy now.
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Advantages of investing in utility stocks
There are 11 stock market sectors. Some are chock-full of high-octane growth stocks -- like the technology, consumer discretionary, or communications sector. Others can soar during economic expansions -- like industrials and financials. The utility sector doesn't have the glitz and glam of some flashier sectors. But it has consistency and stability in spades.
A good chunk of the Vanguard Utility ETF is in electric utilities that work with regulators and government agencies to set prices. The idea is to reward these companies for their services without allowing them to take advantage of consumers -- since a handful of utilities tend to dominate a particular region.
The business model is tailor-made to return capital to shareholders through dividends. Unsurprisingly, many utility stocks have stable and growing payouts. The Vanguard Utility ETF also includes water and natural gas utilities, as well as companies that invest in power generation projects in renewable energy and fossil fuels. The ETF's dividend currently yields 3.1%, and has a price-to-earnings (P/E) ratio of 22.7 -- giving it more than double the yield of the S&P 500 and a lower P/E (the S&P 500 has a P/E of 27.9).
Aside from the consistency of many top utility stocks, another reason why the sector may be doing especially well this year is due to years of underperformance. The Vanguard Utilities ETF had nearly no gains from 2021 to the end of 2023 -- drastically underperforming the S&P 500.
An individual stock or sector can really soar when it is out of favor for some time and then becomes in favor. In other words, the utility sector had some catching up to do and now looks like a fairer value. But is it the best sector to buy now?
Understanding the importance of capital allocation
The outperformance of the utility sector in 2024 is a good reminder that there are plenty of excellent investment options that fall outside the spotlight. It shows that solid gains can be made without chasing high-growth names. The reasonable valuation and high yield of the Vanguard Utilities ETF make it a great choice for risk-averse investors. However, it may not be the best buy for investors with a higher risk tolerance who are focused more on capital accumulation than capital preservation.
The best investments in the stock market tend to be companies that efficiently reinvest capital into the business. Paying dividends or buying back stock benefits shareholders, but also depletes the amount of dry powder that can be used to grow the business. The key is to find companies that reinvest what makes sense without being wasteful.
For example, Coca-Cola and Procter & Gamble pass the bulk of their profits to shareholders through dividends and stock buybacks. This makes sense, given that these companies can only make so many acquisitions or pursue so many market opportunities before the risk outweighs the reward. However, both stocks have rewarded investors with solid long-term gains and passive income. They are masters of capital allocation in a way that suits their business models.
By comparison, companies like Microsoft and Apple reinvest plenty of capital back into their businesses, but they also buy back stock and pay growing dividends. They have more compelling opportunities to grow their businesses than consumer staples companies like Coke or P&G, but not so much that it makes sense to pull the growth lever with reckless abandon.
Then you have companies like Nvidia and Amazon that pour profits back into the business to pursue innovation. Their objectives are to take market share, grow the business, and then reward shareholders with capital gains or dividends down the road.
Like most aspects of life, investing is a balancing act. An effective capital allocator that pounces on market opportunities and executes well is virtually unstoppable. But this approach has added risk, as investors are less likely to stick around if investments aren't translating to growth.
Let utilities work for your portfolio
The Vanguard Utilities ETF can be a great tool for any investor. For some folks, it could be the star player, and for others, it could serve a supporting role. The good news is that the sector still isn't overvalued, and the yield is sizable relative to most other sectors and the major indexes.
There's a limit to the growth of utilities, especially regulated ones. Investors seeking higher risk and higher potential reward may prefer to target top growth stocks or a low-cost ETF like the Vanguard Mega Cap Growth ETF.
