Want Dividends? Try Individual Stocks Instead of ETFs

PRESCOTT, Ariz. (TheStreet) -- According to the StateStreet Global Advisors Web site the S&P 500 SPDR (SPY) has a trailing yield of 1.98%. Reports on CNBC have it up near 2.25%. Either figure is greater than the yield on the 10-year U.S. Treasury, which yields 1.77%. It is rare when stocks yield more than the 10-year Treasury and no doubt increases the spotlight on dividend paying stocks.

Dividend-based ETFs first came on the scene in 2003 with the iShares DJ Dividend Select ETF ( DVY) and the SPDR S&P Dividend ETF ( SDY) and started to proliferate when fund provider WisdomTree created an entire product line devoted to dividend investing. Back then, I wrote articles on just about all of the dividend ETFs as they came out and offered this same caution on just about all of them: if anything serious were to happen to the financial sector then the dividend funds would get hit very hard as most of them are very heavily weighted in that sector.

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DVY and SDY peaked in May 2007 and bottomed out with 64% and 58% declines respectively compared to a 54% decline in the same time period for SPY. Before the financial crisis DVY had a 40% weighting in the financial sector and SDY had 25% which compared to 22% for the S&P 500 back then.

Today DVY is down to a 10% weighting in financials and SDY has dropped to 19%. The current makeup of the two funds is noticeably different. DVY has a 31% weighting in utilities followed by an 18% exposure in consumer goods. The largest sector in SDY is consumer staples at 20%, followed by financials at 19% and utilities at 13%.

Similar to 2007, should there be some sort of event that seriously harms utilities stocks, then DVY will lag behind SDY since the latter only allocates 10% to utilities. In 2007, the threat to the financial sector was the inverted yield curve.

Today the threat to utilities is interest rates that seemingly cannot go lower. Historically, rising rates are bad for utility stocks as more attractive bond yields are viewed as safer competition for investment capital. Guessing when interest rates will go up is obviously difficult and seems like it is at least a couple of years off. But when rates do go up, utility stocks and funds heavy in that sector are likely to get hurt.

For investors looking to build a dividend-centric portfolio it may make more sense to work from the bottom up, choosing individual stocks instead of a broad fund that may include weightings to other sectors. Those weightings might also change based on how the market performs.

In addition to having more control over sector weightings an investor choosing stocks will probably end up with a better yield as well. Altria ( MO) yields 5.1%, Verizon ( VZ) yields 4.8% and Westpac Banking ( WBK) yields 7.8%. DVY and SDY have trailing yields of 3.47% and 3.27% respectively. There is no free lunch here either. Individual stocks expose the portfolio to the consequence of poor choices vs. ETFs and possible poor sector allocations.

The conclusion here is not that there is an easy out -- quite the opposite. The financial world has become far more complicated in the last 10 years. ETFs are great tools that will be the best choice for certain segments, but not every segment. For now, they are likely not the best choice for domestic large-cap dividend strategies.

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