Don’t get tangled up in utilities

The normally sedate world of utility stocks has gotten a jolt of energy lately. Spooked by the prospect of a major stock market correction, investors have flocked into the classic safe haven of utilities. As of mid-April, the S&P 500 utilities sector had racked up an 11.3% gain for 2014, far surpassing the 1.8% rise in the broader market. Utilities’ allure has been lifted by the sector’s hefty 3.6% dividend yield, nearly double the 1.9% payout for the S&P 500. But many experts are now warning that the run-up in utility stocks has gone too far and advising investors to look elsewhere for shelter from market volatility.

The first red flag is the sector’s rich valuation. Goldman Sachs utilities analyst Michael Lapides, who recently downgraded the group from neutral to a cautious rating, notes that utilities are currently trading at almost 15 times estimated 2015 earnings. That’s significantly above their average forward price/earnings ratio since 1990 of 13. The recent surge in utility stocks “is an opportunity to reduce exposure,” he says.

Long-term operating earnings for utilities are expected to grow by just 4.25% annually, according to S&P Capital IQ — far below the 12% growth rate expected for the broader S&P 500. There are several reasons for the low expectations. Electricity consumption has been trending lower in recent years, partly because of alternative sources of energy. Regulators, who place a limit on the rates that many utilities can charge to customers, have granted smaller increases of late. And utilities have benefited from record-low interest rates to finance their large capital projects. Rising rates plus reduced rate hikes could squeeze future earnings.

Utility stocks have historically underperformed the broad market when interest rates rise, which many observers predict will happen as the Federal Reserve continues to taper its massive bond-buying program. Since 1970, utility stocks have declined by an average of 0.7% per month during months in which the 10-year Treasury yield increased, notes S&P Capital IQ chief equity strategist Sam Stovall, who has an underweight rating on the utilities sector. And that’s pretty much what happened last year, when Treasury rates first began to climb: From May 1 through Dec. 31, 2013, the utilities sector shed 7% of its value, while the S&P 500 surged by 16%.

For a more diversified form of portfolio protection, consider instead low-volatility exchange-traded funds that are specifically designed to hold up well during downturns. A favorite of Morningstar analyst Michael Rawson is iShares MSCI USA Minimum Volatility, whose top holdings include Verizon, Merck, and Exxon. Unlike many of its low-volatility peers, this ETF does not take large concentrated bets on any one sector; utilities currently account for about 8% of the total portfolio. It offers a healthy dividend yield of 2.3% and charges a low expense ratio of 0.15%. The fund has returned an annualized 17.9% since its inception in October 2011, compared with 21.5% for the S&P 500, but with far less volatility. Indeed, a low-volatility fund will typically underperform the broader market a bit if the bull market is going full steam ahead. But for peace of mind, that might be a reasonable price to pay.

This story is from the May 19, 2014 issue of Fortune.

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