For the vast majority of renters and homeowners, electric, water and gas bills are a monthly part of life. However, there is a way to recoup some of the money you pay to your utility companies, albeit indirectly. Utility funds allow investors to get a taste of the profits that gas, electric and water companies reap from their services. This article will examine the nature and composition of utility funds, as well as the type of investors for whom they are appropriate.

What Is a Utility Fund?

Utility funds invest primarily in the securities of gas, water and electric companies that supply water and power to cities and municipalities. They may also invest in firms that supply equipment or services for utility companies. Although utility funds tend to invest primarily in either common or preferred stocks, many of them have a certain percentage of bonds within their portfolios as well. The stocks of most utility companies pay relatively high dividends, regardless of their common or preferred status. Utility funds therefore usually have a primary investment objective of current income, with growth as a possible secondary objective.

Historical Performance
As with real estate and healthcare funds, utility fund performance has a relatively low correlation with the broader markets. Because it is not guaranteed, the dividend income that most utility funds pay is normally higher than that offered by banks or industrial companies. The Dow Jones Utility Average (DJUA) rose from about 125 in 1970 to about 200 in 2002, but deregulation of certain utilities industries and global demand for energy buoyed the index at 450 in 2008.

Utilities were hammered during the fallout of the Enron scandal when they themselves invested in non-utility-related enterprises in the energy and marketing arenas, but sold these extraneous businesses, got out of debt and were largely flush with cash by 2005, helping to draw investor interest to the utility sector. Like most sectors, utilities were hit hard in 2008, with the index dropping down to below 300. However, since then, it has recovered to reach nearly 500.

Advantages and Disadvantages
One of the main advantages that utility funds offer is their relative immunity to market conditions. Like the healthcare sector, utility funds are considered defensive investments; that is, they are sustained by common everyday consumer use and the performance of the markets has little bearing on them. People need gas, water and electricity regardless of current economic conditions, and will therefore have to pay for them.

Furthermore, most utilities are allowed to have a local monopoly over their respective municipalities. This is done in the interest of efficiency, as it would obviously be impractical to lay separate power lines and water and sewage pipes in the same area for competing utility companies. Essentially, this ensures the utility company's continued existence and profitability.

Utility funds also present a couple of disadvantages for investors. The main drawback is that they are sensitive to changes in interest rates. Whenever rates increase, the value of these funds will decline as investors seek the higher yields of bonds and the cost to service utility debt increases. Utility funds also face difficulty at times in passing along changes in energy prices efficiently to consumers and investors due to price regulations. This can translate into little or no gain for investors when the price of energy begins to rise.

What Type of Investor Is Appropriate for Utilities Funds?
Traditionally, utilities funds were sought after by conservative investors seeking stable interest and dividend income. However, the strong performance in the utility sector since 2005 has made these funds more appealing to aggressive investors seeking alternative avenues of growth along with some consistent income. Major index fund benchmarks like the Standard & Poor's 500 Index (S&P 500) may hold between 5 and 10% of utility companies, based on historical averages of their contribution to the total output of U.S. businesses.

So What Utilities Funds Are Worth Looking at?
There are a number of fund offerings in this category, both good and bad. When evaluating a utilities fund, investors should examine the same characteristics as for any other fund. Total return, beta, dividend yield and portfolio turnover are some of the main criteria that should be examined, along with Alpha and R-squared metrics. Morningstar and CDA Wiesenberger provide search and screening services that allow you to quickly find utilities funds with the highest numbers in these categories (a paid membership is required for these services).

When it comes to sector funds, long-term performance is crucial; any sector fund that has not endured at least two complete economic cycles may not accurately depict the average total return the investor can expect to receive over time. Funds that have not been around for one complete cycle are especially suspect. As such, utilities funds that have only been through bear markets, when this sector tends to perform well, warrant particularly close analysis.

The Bottom Line
Although utility funds have traditionally been considered defensive investments, they have gone on the "offensive" in recent years, posting strong gains normally seen in more aggressive sectors. However, conservative investors seeking income can most likely continue to rely on these funds to pay competitive dividend rates over time. For more information, visit Morningstar or consult your financial advisor.