XLU - UTG: Now's Your Chance To Board

2023-04-03 10:40:13 ET

Summary

• Reaves Utility Income Fund has underperformed the Utilities Select Sector SPDR ETF over time.
• However, there are potential opportunities for UTG investors to exploit when it gets hammered more steeply than the XLU.
• We discuss why the relative undervaluation of the utilities sector to its 10Y average could help propel such a move.
• Also, price action in UTG is constructive, suggesting investors rotated rapidly out of leveraged CEFs, as it reached a bottom in October.

Reaves Utility Income Fund ( UTG ) is a close-ended fund or CEF that uses leverage to invest mainly in utilities companies. It has 65% exposure to companies in the utilities sector, with communications accounting for about 19%. UTG also has a nearly 9% exposure to real estate, as it delivered a forward yield of about 8%.

Notably, UTG uses approximately 20% leverage in its portfolio. As such, the surge in interest rate hikes over the past year impacted its performance.

As seen above, the rapid rise in interest rates hurt UTG's performance significantly, sending it into a steep downtrend against the relative strength of the 10Y Treasury yield. However, investors should also be able to glean that the relative underperformance has leveled off since October 2022.

As such, investors who wanted to bail out of utilities-linked funds/stocks because of their exposure to interest rate risks have likely left. The remaining bagholders in UTG are likely betting on a Fed pivot moving forward.

Financial markets have been pricing in a pivot, which could be gleaned from the outperformance of risk-on sectors in 2023. Hence, UTG bulls could argue that the worst is likely over, which was our thesis back in December.

However, whether UTG buyers are attracted back and buy into the current levels will likely depend on whether the relative reward-to-risk profile is attractive.

According to Morningstar's risk/return framework for UTG, the CEF underperformed its category and index benchmark. As such, holding UTG for its higher yield has not resulted in a higher risk-adjusted return.

Hence, investors must ask whether UTG's forward yield of 8% is really worth more than the Utilities Select Sector SPDR ETF's ( XLU ) 3.1% forward yield?

UTG Risk & Volatility Measures. Data source: Morningstar

UTG hasn't driven alpha for investors compared to its category and index benchmark, demonstrating that its use of leverage has not resulted in better performance. In contrast, the XLU delivered trailing alpha of 2.39 , which is better than its index benchmark.

Therefore, investors holding UTG over the past ten years have underperformed the XLU. Despite that, keen-eyed investors can glean the relative outperformance of UTG over XLU for about two years from the 2009 financial crisis lows.

The thesis is that UTG was sold off much more steeply than XLU during the last crisis as investors deleveraged. However, the capitulation move also preceded a sharp mean-reversion opportunity that bottom-fishing investors capitalized on.

The critical question is whether UTG's recent bottoming process since December 2022 could mark the possible start of a similar move.

We observed that UTG had underperformed the XLU significantly since June 2011, with the move indicating a capitulation in UTG/XLU's long-term chart.

Hence, the mean-reversion thesis is possible if utilities stocks are undervalued relative to their long-term mean.

UTG last traded at a P/E of 19.4x, below the utilities sector 10Y average of 21.2x . Hence, the potential for a mean-reversion outperformance opportunity is possible, even though investors will need to be nimble and not hold UTG as a core long-term holding (given the relatively poor reward-to-risk profile).

Given the recent sector rotation out of utilities stocks, we believe the opportunity is timely, coupled with our conviction that the sector's October lows will likely be sustained.

Rating: Speculative Buy. (See additional disclosure below for important notes accompanying the thesis presented.)

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