The U.S. utility sector has performed remarkably well this year. The defense sector has benefited from relentless geopolitical tensions stretching from Russia to Iraq that has resulted in elevated levels of risk-off trade sentiment among investors.

The utilities sector is known for its non-cyclical nature and often acts as a safe haven amid market turmoil. The broader utility ETF Utilities Select Sector SPDR XLU returned around 5% in Q1 while SPY advanced only 2.2%. High beta, tension between Russian and the West, and a freezing U.S. economy led to this noteworthy differential in return.

Though the momentum slowed in Q2, as evident by a 0.2% return provided by XLU versus 2.6% gain in SPY, the sector was still afloat in the U.S. market rally. Over the last one month (as of September 17, 2014), XLU has gained about 2.6% while SPY is up 1.6%.

What Made Utilities a Huge Hit This Year?

Long-term interest rates have been on a downhill ride this year. Yield on 10-year Treasury note fell 38 bps to 2.62% (as of September 17, 2014) from 3%. Many companies in the utilities sector pay out more than that to investors on a regular basis while still allowing for capital appreciation. As a result, yield-hungry investors flocked into the safe utility ETFs in search of yields (read: 3 Utility ETFs Surviving the Market Turmoil).

The sector is also capitalizing on booming population, which is spurring the need for utility supplies like water and power. Notably, the products that the sector offers, including power and water, can be viewed as essentials having steady demand and not exposed to economic growth cycles (read: The Comprehensive Guide to Utility ETFs).

Given this combination of value and yield, along with the defensive nature of the space, it could be time to give this segment a closer look. Below we have highlighted three utility ETFs that have generated the highest return in the space so far this year.

S&P Equal Weight Utilities ETF (RYU)

RYU looks to track the S&P Equal Weight Utilities Index. All the components within the fund are given equal weightings. No stock accounts for more than 3.26% of the fund. The ETF presently holds 35 securities with total assets of $83.4 million and 27% allocation toward the top 10 holdings.

The fund is slightly more expensive than the other products targeting this sector. It charges investors 40 basis points and has paid out a yield of 2.87% per year (as of September 17, 2014). RYU is 17.5% up year to date.

Utilities AlphaDEX Fund (FXU)

The fund employs a unique AlphaDEX methodology of stock selection, which uses fundamental growth and value factors in order to pick securities. Various fundamental analysis factors are used to shortlist stocks. The stocks are then scored on the basis of these parameters with the top 75% stocks entering the fund portfolio.

The unique methodology comes with a fat price for investors, as they are charged 0.70% in expenses. The fund holds 44 securities in its portfolio currently and allocates around 40% in the top 10 holdings.

FXU has amassed about $214.4 million in assets so far.  The fund has added about 15.6% so far this year and yields around 2.6% (as on September 17, 2014).

XLU in Focus 

XLU is by far the biggest, as well as the most liquid, ETF targeting this space tracking the Utilities Select Sector Index. This index holds 32 securities in all and has net assets of $5.39 billion. The ETF is appropriate for those investors who are looking for a targeted bet on regulated utilities, as well as independent producers and traders of power.

The fund targets the biggest companies in the space. The ETF is heavy on its top 10 holdings, with about 59% going to these stocks. XLU returned about 15% to date and has a dividend yield of about 3.49% (as on September 17, 2014).

Bottom Line

Investors should note that the Fed is likely just one month away from leaving the QE era which started in 2008. While the Fed cut its QE stimulus by another $10 billion this month, its dovish commitment to keep the interest rates at a rock-bottom level for a ‘considerable time’ is adding cheer to the stock markets.

However, the Fed has also indicated a possibility of faster-than-expected rise in rates once the hike procedure takes place. All these might keep utility ETFs under pressure once the Fed starts raising rates (read: Can Utility ETFs Regain Their Lost Momentum?).

However, there is a bullish case scenario too. Though utilities underperform in a rising rate environment, they normally deal with long-term interest rates to fund the heavily indebted capital intensive projects. So, a faster rise in short-term interest rates might cause less damage to this space.

Secondly, the broader stock market might witness a short-term sell-off following the rate hike, which might brighten the safe haven appeal of these stocks and the related ETFs. In any case, next year is not going to be as smooth as most of this year was for utilities.