Long/Short Investments
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Long/Short Investments in L/S Equity: Valuation and Ideas,

The Importance Of Utilities Exposure In A Portfolio

I believe that it may be prudent for some/most portfolios to have some level of exposure to the utilities sector for the diversification benefits it provides.

As most know, utilities are highly regulated entities in order to ensure that they provide adequate water, electricity, and other needs to all households. This is made to ensure that some parts of the population are entitled to these services irrespective of the utility company’s ROI.

As such, utility companies can only charge so much to each customer and have fairly predictable cash flows year to year. This results in less dispersion in the market’s valuation opinion of any given utility company and reduces volatility.

The average utility company has only slightly more volatility than the S&P 500 as a whole – notable given that over 500 companies make up the index and work to hedge against wide valuation swings.

Correlations & Returns

Since December 1998, the S&P 500 and the US utilities sector (as represented by the ETF XLU (longer history than the Vanguard equivalent, VPU)) has had an average +0.62 correlation with each other.

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Around the time of the financial crisis, the correlation was above average – as is typically the case when liquidity is low – and has been markedly below average since the beginning of 2016.

A portfolio that is 50% SPY and 50% XLU (or VPU) will reduce annualized volatility by approximately 14% over a 100% SPY portfolio. Moreover, it reduced maximum drawdown by about 640bps over the 18+-year backtest period that included both the dot-com crash and financial crisis. (The “timing portfolio” line item below can be ignored and is based on volatility control.)

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This is very far from a “balanced” portfolio, as both assets are equities. Each will outperform on a risk-adjusted when growth exceeds embedded expectations. Stocks on aggregate will outperform when inflation exceeds expectations, while utilities are more inflation-neutral.

So the actual diversification is quite low with just a 14% risk reduction. (I think one can flush out 60% of the risk while minimally impacting expected returns, which I cover in a separate post.) But it nonetheless illustrates the ability of how a very basic level of diversification has the ability to improve a portfolio’s reward-to-risk ratio to better risk-adjusted returns.

Utilities Sector Fund Holdings

Vanguard’s utilities sector ETF, VPU, contains 75 holdings (74 stocks plus a small cash component). They are listed below.