Utility Investors May Be Due for a Jolt of Reality

There’s a real danger that shareholders in utility mutual funds could get zapped soon.

Fueled by a recent drop in interest rates, these popular investments--which hold a combination of electric, natural gas, telephone and water stocks--returned nearly 6% including dividends during the third quarter of 1993, according to preliminary results from Lipper Analytical Services.

That gives the funds a 12-month gain of 20% and a compound annual return of 16% over the last decade.

In an era when money market funds and certificates of deposit are paying 2% to 4%, investors have been quick to notice such standout performance. Unfortunately, the flood of cash into utility funds is probably setting up a lot of people for a rude shock.

“At some point, (interest) rates will rise, and utilities will feel the brunt of any increase in rates,” predicts Dow Theory Forecasts, a newsletter based in Hammond, Ind. “The largest part of the advance in utility stocks is probably behind the group.”

Utility funds aren’t alone in this respect. Bond funds will also short-circuit when interest rates turn higher.

Even stock portfolios could get hurt. There’s no way to predict when rates will rise, of course, but the bottom might not be much further away.

“My fear is that people will jump into the utility sector without realizing the risk they’re taking on,” says Daniel P. Wiener, editor of the Independent Adviser for Vanguard Investors, a Boston-based newsletter.

Anyone who believes utility funds have access to an inexhaustible source of investment power may be in for a jolt of reality. Risk-averse individuals should be careful about plugging into the utility grid at this late stage, for several reasons:

* Recent performance isn’t sustainable. When you consider that the stock market in general has historically gained about 10% a year on average, it’s hard to believe that a more conservative type of investment should be rising at a 16% annual clip.

In fact, the leading fund in the group, Prudential Utility, now has a better 10-year performance record than Fidelity Magellan. Prudential Utility and Fidelity Select Utilities are both on Lipper’s Top 10 list for all mutual funds over the last decade.

* Interest rates pose a danger. Utility funds are especially sensitive to interest rates for two reasons. First, utility companies are capital-intensive and thus could face higher borrowing costs if rates should rise.

Second, the stocks pay relatively generous dividends and thus, like bonds, are valued primarily for the income they throw off. When interest rates increase, existing income investments drop in price to remain competitive with new issues.

* A sales stampede is on. Prudential reports that its utility portfolio is its best-selling mutual fund for the year to date. Other companies are reporting similar marketing success.

Several fund groups have introduced utility portfolios in recent months to cash in on the craze. Lipper now counts 53 such funds, with $24 billion in assets.

A year ago, there were 37 utility portfolios with a combined $15.6 billion. Investors often get burned when they rush into overheated sectors.

* The funds are going global. Many portfolio managers have been boosting their holdings of foreign utility stocks in an effort to capitalize on attractive growth and income opportunities.

There’s nothing wrong with taking a global perspective, but it’s important that investors understand the potential for greater risks.

In addition to the usual stock market and interest rate dangers, investors in foreign utility shares could get hurt if the dollar increases in value, thereby reducing the value of non-U.S. investments.

The average utility fund now has about 10% of its assets overseas, says Morningstar Inc. of Chicago.

Prudential Utility, Flag Investors Telephone Income and Invesco Strategic Utilities--all respected funds--are among those with at least a 15% weighting.

In short, purchasing a utility fund today is probably more risky than it has been in years. These worthy investments can make sense as part of a diversified portfolio, but shareholders should realize that the sizzling gains can’t last forever.

New Funds in Family

Sogen International ((800) 334-2143), a well-regarded asset allocation fund, is no longer an only child. Societe Generale, the French bank that owns the management company, has come out with three new funds.

One is a money market portfolio; the others concentrate on foreign stocks and gold companies. All will be run by Jean-Marie Eveillard, manager of Sogen International, which enjoys a top five-star rating from Morningstar Inc. of Chicago.

The money fund is a no-load, but the other three portfolios carry a maximum 3.75% sales charge.

Opening South Africa

Don’t be surprised to find a South African stock or two in your socially conscious mutual fund soon. The funds, which for years refused to invest in the white-dominated country because of apartheid, last Tuesday announced they would reverse that policy.

“We are responding immediately to Nelson Mandela’s appeal at the United Nations to remove all sanctions against South Africa,” read a statement from a group that included the Calvert mutual funds, the Dreyfus Third Century Fund, the Parnassus Fund, the Domini Social Equity Fund and the Working Assets fund group.

Mandela, leader of the African National Congress, made his appeal and urged massive investment in the country in a speech to the world body Sept. 24.

Calvert’s Social Investment Fund claims credit for being the first mutual fund to take a stand against apartheid back in 1982.

Plugged Into Growth

Mutual funds that hold utility stocks are riding a popularity wave. Some observers worry, however, that new shareholders might not realize that recent gains by these funds have been well above average and aren’t likely to be sustained.

Utility fund assets 1993: $24 billion

Number of funds 1993: 53

Note: All figures are for the third quarter of each year. Source: Lipper Analytical Services