Finding the Funds
This required some rooting around since the range of possible fund structures could include mutual funds, ETFs, closed-end funds and split capital shares. We had to check various filters and research tools like GlobeInvestor's Funds page, FundLibrary.com and TMX Money, whose down-loadable list on the Structured Products page turned out to be the most useful, as it included all our candidates below. It seems that there is not a single Canadian mutual fund specialized in Utilities stocks at the moment. The comparison is still something of a challenge, comparing not just apples and oranges but grapes and bananas too. That's the messy reality we investors face!
1) Utility Split Trust - This is a split capital corporation, with the same structure, features, pros and cons as described in two recent posts on split preferreds and on capital shares. We list both the Capital shares and the Preferred Shares below as possibilities since an income oriented investor might want either. One concern is that the corporation is due to close down in December 2011, with holdings liquidated and Net Asset Value returned to shareholders at that time. If the managers First Asset Funds Inc think investors still want it, there could be a proposal to extend its life beyond the intended five-year lifespan.
- Capital Shares (TSX quote: UST.UN)2) Utility Corp (UTC.C) - This is a closed-end fund (see our previous post on CEFs) due to mature and wrap up in May 2013, though this looks unlikely as the managers Scotia Capital issued warrants in September 2010 to double the size of the fund.
- Preferred Shares (UST.PR.A)
3) Canadian Utilities and Telecom Income Fund (UTE.UN) - It's a brand spanking new closed-end fund, just out of the Initial Public Offering December 17, 2011. There is no track record, so the only comparisons we can make are based on the prospectus.
4) BMO Equal Weight Utilities Index (ZUT) - This ETF has the best-sounding stock symbol but that isn't necessarily a reason to invest. It is only one year old, so again we must infer from available information.
Dividend / Distribution Yield and Value (click to enlarge table)
The current payout of the funds, per the Dividend Yield and Value table above, exceeds that of the individual companies rated top quality in our previous blog post individual company analysis (green highlighted rows), except for that of TransAlta. That would be fine except that dividends are only part of the return, especially for the long term hold investor.
Past Returns - Individual Stocks Outshine Funds
The five year share price graph below, taken from TMX.com, shows how much UST.UN fell behind the TSX Composite. UTC.C more or less kept pace with the TSX while our top three stocks - EMA, CU and FTS - to make a bad pun, "powered" ahead of the TSX and UST.UN. The management fees (MER) of the various funds drag down net returns for the investor. Individual stocks do not have any on-going management fees. There is a price to pay for the diversification gained by a portfolio and the MER is it. UTC.C and UST.UN both have MERs over 1%. A key stated objective of UTC.C's warrant issue is to reduce the MER by spreading costs over a larger asset base. Doubling the UTC.C asset base probably will not reduce the MER by half but it should help a lot.
In the past year UST.UN has done much better, second behind EMA, and UTC.C has fallen well behind the others since its warrant announcement in September. Which will do better in future? That is ever the unknown factor.
The UST.PR.A preferred shares look to be a poor investment at the moment. The yield to maturity in December this year, is a paltry 0.1%. As opposed to the current dividend yield of 5.7% (dividend /stock price), the yield to maturity calculation takes account of the fact that the stock price at $10.59 is above the December redemption price of $10, i.e. a capital loss will occur.
DRIP - For investors who wish to plow back their dividends into shares, the best individual stocks, with both a free DRIP program and a discount on such new purchases, such as EMA, FTS and TA, are clearly better the funds. BMO's ZUT at least offers a free DRIP.
Distribution Tax Types - There is little to mark funds or individual stocks as better for an investor's taxable account since the distributions are mostly all dividends, though for the moment UST.UN is handing out only Return of Capital (ROC). The funds, especially the active funds - UST.UN and UTE.UN - may distribute capital gains in future. In contrast, with individual stocks, it is the investor him/herself who decides when to sell stock and realize capital gains. Within a registered account, none of this matters of course, as tax is only applicable when funds are withdrawn from the account.
Liquidity - The funds are weaker than the individual stocks in terms of trading costs, as measured by wider bid-ask (sell-buy) quote spreads, and trading volumes, which determine how easy it is to set up a holding or sell out as needed. ZUT is best of the funds with a low bid-ask spread. UTC.C's bigger capital base should help it after all the warrants are exercised in the next few months. For a long term hold investor, this factor is not a major consideration.
Safety and Stability - On what is probably the most important dimension to the income investor, the individual stocks, especially the top companies in our previous ratings, look much better than three of the funds, though UTC.C comes out looking reasonably good.
Three of the four company stocks - EMA, FTS and CU and one fund, UTC.C, survived the 2008 crash with much less of a price decline than the TSX Composite as the graph below from Google Finance shows. That's the stability we seek. UST.UN fared even worse than the TSX Composite.
The situation is the same on dividends. Whereas all four of the top stocks have had at least one dividend increase, and no decreases, UST.UN went through two significant chops in 2008 and 2009 before an increase in 2010. UTC.C did what one would hope. It increased dividends in all three of the most recent years.
Another measure of stability is how closely the funds sell for what they are worth, in other words the Net Asset Value of the holdings within the fund. As is typical of Closed-end funds and Split shares, these funds are all trading at a considerable discount - UST.UN (-9.6%), UTC.C (-5.3%) - or premium - UTE.UN (+11.4%) - to NAV. The ETF ZUT is working as intended and typical for ETFs, trading very close to its NAV. Some might consider this a trading opportunity to buy a fund for less than it is worth, but suppose the fund is at a discount when you want to sell, is that helpful?
UST.UN adds risk through the use of leverage (borrowed money, through its split share structure), while UTE.UN's prospectus says it may borrow. UTC.C is totally passive and never trades, not even to rebalance, which is contrary to the usual fund risk management principle of rebalancing regularly.
The preferred share UST.PR.A is quite safe according to the investment grade DBRS rating of Pfd-2 (low).
Holdings - Three of the Funds Look More Speculative (click on table to enlarge)
When we look inside the funds at their holdings, we discover that in addition to the top companies, ZUT contains most of the companies we judged to be of middle and lower quality. If you agree with our assessment then perhaps unstable income will be mixed with possible big capital gains, or losses, in ZUT. UTC.C in contrast, holds only the top electric power companies and a broader mix of large well-known firms in other utility sub-sectors. Though we have not assessed these other holdings, they are more reassuring than worrisome for UTC.C.
UST.UN and UTE.UN both lack transparency. We cannot really tell what is inside since neither reveals the entire portfolio. Both appear to contain companies in our middle quality group and other smaller cap companies. In addition, both are actively managed so we must put our faith in the managers.
Bottom Line
From an income investor's viewpoint, despite the lack of diversification gained from multiple holdings, the best company stocks, even held individually, seem to have done as well as the best fund currently available in Canada - UTC.C - in terms of reliable increasing income and stable safe capital value. The other funds appear more suited to those who seek a combination of fairly reliable income and possible though not assured capital gains with greater volatility along the way.
Maybe we are discovering the meaning of legendary investor Warren Buffett's words (from Wikipedia):
"The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it."
A possible course of action, for the investor who has sufficient capital to buy large enough holdings, would be to buy and hold all the top four electric power utilities - FTS, EMA, CU and TA. However, this is not the end of the story or necessarily the moment to buy in. We have not delved that deeply into the companies to pretend that we know the business in the way Buffett means.
Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.
