Utility investments typically benefit from stronger economic activity, and a top Canadian utilities ETF will let you take advantage of this—if you watch for low fees and sound stock holdings

Utility stocks are shares in companies that provide electric power, telecommunications, pipeline services and so on. Canadian utility shares have always been great sources of tax-advantaged distribution income.

While most utility stocks are steady income producers, some utilities also offer opportunities for growth. This happens mostly when utilities expand into new markets or geographic regions.

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We still feel that investors will profit the most with a well-balanced portfolio of high-quality individual stocks, but ETFs can also play a role in a portfolio.

Holding utilities, or a Canadian utilities ETF, can be a sound component of most investor portfolios.

Characteristics of the best utility investments

The best utility stocks, or ETFs that hold them, can deliver predictable, lower-risk dividends.

Traditionally, the utilities sector is said to suffer when interest rates rise—or if the market is worried about a rise.

This is because utilities typically have a lot of debt as part of their capital structure, and higher rates make it more expensive to raise money and refinance existing debt. As well, their shares, which typically offer high yields, compete with fixed-income instruments for investor interest.

However, higher interest rates are usually accompanied by increased economic activity and growth. That stronger economic activity is good for utilities: It pushes up demand for their power and so on and at the same time boosts the electricity rates they charge their customers.

Regardless of those positives, as interest rates rise, investors often sell off, or avoid, utilities stocks, and that can push down their price. Given the formula for dividend yield—specifically, annual dividend rate/stock price—a falling stock price (the bottom number in the fraction) pushes up the yield. In other words, when the stock price goes down, its dividend yield goes up.

When looking for investments in the utility sector, investors should avoid judging a company based solely on its dividend yield. That’s because a high yield can sometimes be a danger sign rather than a bargain. For example, a company’s dividend yield could be high simply due to its share price having dropped sharply (because you use a company’s share price to calculate yield). That low price can be a sign of an imminent dividend cut.

Apart from a good dividend yield, the utility stocks you invest in should have a long history of paying (and raising) their dividends. For a true measure of stability, focus on those companies that have maintained or raised their dividends during economic and stock-market downturns.

High-quality Canadian utilities ETFs will offer lower fees through passive management

The best ETFs are focused on simple goals. Instead of picking and trading investments, operators of these ETFs manage investors’ money “passively,” with the goal of duplicating the performance of a market index. This lets the operator charge very low MERs (management expense ratios) compared to an average MER on conventional mutual funds of 2%-3%.

Thanks to the lower fees, these ETFs routinely perform better than many actively managed mutual funds. That’s because only a minority of mutual funds beat the index by a wide enough margin to offset their MERs. However, like a lot of investment products, ETFs have become far more varied, and more profitable for the operators.

“Plain-vanilla” ETFs—the kind with ultra-low MERs that set out to mimic a broad-based, long-standing market index—are attractive alternatives to many conventional mutual funds. That’s especially so when you’re investing limited funds. We recommend a number of these ETFs in our Canadian Wealth Advisor newsletter. We also recommend a handful of ETFs that fulfill narrow investment goals such as investing in a number of stocks from, say, a particular country.

The liquidity of a Canadian utilities ETF can lead to costly frequent selling

ETFs can cut the cost of investing, but they can balloon your risk. For instance, ETFs trade on stock exchanges, just like stocks. So, you can buy or sell any time the market is open.

If you take advantage of this liquidity to trade in and out of ETFs, you can wind up losing money by getting out of your best ideas too soon, or making less than you would have if you had simply held on.

Know the difference between “top-down” and “bottom-up” investing when you look for a Canadian utilities ETF

 Unfortunately, rather than helping investors make more money, ETFs may spur them to act on their own trend-following or theme-investing urges. This is called “top-down investing.” It essentially involves investing on predictions, by making what you might call side bets on market or interest-rate trends, currency spreads, industry bubbles and so on.

Most investors are far better off with “bottom-up investing.” That’s where you look closely at individual stocks and single out those with a history of sales and earnings, not to mention dividends. Then you buy a diversified, balanced selection of stocks—or ETFs that hold those stocks—that appeal to you as individual, prosperous businesses.

 Bonus tip: Use our three-part Successful Investor approach when building your overall portfolio—including adding in a Canadian utilities ETF

• Invest mainly in well-established companies;
• Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
• Downplay or avoid stocks in the broker/media limelight.

 How has the threat of rising interest rates affected your interest in Canadian utilities ETFs?