Sector ETFs and Dividend-Paying Stocks - Should You Buy Them?

Roger Nusbaum just published an excellent piece outlining his investment strategy. He says he uses sector ETFs and supplements them with individual dividend-paying stocks, and concludes that "What I have laid out above is my approach with ETFs but this is absolutely a subjective thing and just because I believe in one way doesn't make it right for anyone else."

Here are the arguments for the opposite approach: the case for avoiding sector ETFs and dividend-paying stocks. Hopefully a lively debate will help investors make the best decision!

First, dividend-paying stocks.

Dividend-paying stocks are superficially attractive, particularly if you think the market is range bound. If stock prices aren't rising, why not at least collect dividends? Here's a detailed examination of that argument that may make you less enthusiastic about buying dividend paying stocks.

If you do decide to go for dividend-paying stocks (and there are many smart people in addition to Roger who think you should), should you buy a dividend-paying stock ETF like DVY or PEY, or individual dividend-paying stocks?

• The problem with dividend-paying stock ETFs like DVY and PEY is that their relatively high expense ratios cut into the dividends you receive. And because they don't contain that many stocks, it may be cheaper for you to simply buy the underlying stocks yourself. That's particularly true if you are planning to hold the position for a long period of time, in which case the one-off costs of buying and selling the underlying stocks matters less, and the annual expenses charged by the ETFs matter more. Here's a discussion of the pros and cons of dividend paying stock ETFs.
• Buying individual dividend-paying stocks has its own risks. If you simply choose stocks with the highest dividend yields and ignore factors like dividend coverage and earnings growth, you may find that the dividends are not sustainable and get cut. Sandy Cohen ranks utility stocks by dividend yield on The Utility Stock Blog, but he doesn't think investors should invest on that basis alone.
• Buying individual dividend-paying stocks also has another downside: you're concentrating your portfolio, and that raises your risk. If you have a reasonable proportion of your portfolio in, say, ten dividend paying stocks, your maintaining a much more concentrated portfolio than one built of broad-based ETFs.

What about sector ETFs?

Sector ETFs have their own problems:

1. Their expense ratios are higher than broader-based ETFs.
2. They are far more concentrated, often dominated by three or four mega-cap stocks.
3. They are less liquid than broader-based ETFs, and that means you may pay more in buy-sell spreads.
4. They make your portfolio more complex and expensive to manage than focusing on a few broad-based ETFs.

But sector ETFs do have two advantages: they provide more opportunity for portfolio rebalancing, and, if you have a proven track record at beating the market, they allow you to make more money than with broader market-tracking indexes.

There's a detailed discussion of the pros and cons of sector ETFs here in The Radical Guide to Investing, a free online book about investing with ETFs.

Where does that leave us? My suspicion is that most investors are best off building portfolios from broad market ETFs, with perhaps some closed-end funds for particular foreign markets. In the long run your transaction costs will be lower, the expense ratios you pay will be lower than using sector ETFs, and you'll avoid a questionable bet on dividend-paying stocks.

As Roger said at the end of his piece, this is opinion. Hopefully the debate will help investors make the best decision.