Power Your Portfolio

Those who read my articles regularly or subscribe to my Motley Fool Income Investor newsletter know that I'm selectively bullish on the utility sector, which I believe offers investors seeking stable income and growth from their portfolios a reasonably safe place to play (provided they choose wisely). It shouldn't come as a surprise, then, that a few of my newsletter recommendations over the past year have been electric, gas, or water utilities.

As a supplement to those holdings, or as a means of providing our readers with the ability to quickly, easily, and inexpensively gain some broad exposure to this sector, I've also introduced our subscribers to the world of exchange-traded funds (ETFs). Today, I'd like to combine the benefits of the utility sector with the efficiency of ETFs, and offer you some investments that should help power your portfolio.

ETFs are basically mutual funds that trade throughout the day like ordinary stocks. These investments often provide investors with a low-cost option for enhancing the diversity of their portfolios. For the full monty on ETFs, along with more specific ETF recommendations, you can check out the latest Income Investor special report, The ABCs of ETFs, by taking a free trial (if you're not already a Fool member, you can also get the report for free by registering). If you only have a minute to learn about ETFs, this guide tells you all you need to know.

Code red
You need look no further than Duke Energy (NYSE:DUK), Dynegy (NYSE:DYN), and Williams Companies (NYSE:WMB) to see that utility stocks have experienced their share of pain over the past few years. In fact, it's been nothing short of a nuclear meltdown. However, the overall sector is on the mend, and continues to offer some of the most favorable dividend yields available.

It's true that the sector is still facing some overcapacity, and significant increases in the demand for power aren't likely to occur in the next few years. However, the strongest companies in the sector are still performing well, and their yields are substantial enough to reward you while you wait.

Brighter days
Though it's somewhat susceptible to economic growth factors, electricity is not an optional commodity. In other words, if you think light, air conditioning, hot water, and flipping back and forth between reruns of M*A*S*H and Seinfeld are necessities, you'll be paying up for power. That means the current oversupply will be worked off eventually and, again, the substantial dividends provided by this sector mean you'll get paid in the short term while that happens.

There are also some political factors at play that would allow for consolidation in the industry, which could be a significant positive for the utility sector. Further, lately sales of power-generation assets have been increasing, and they're fetching much more favorable prices than the market has seen in several years. That's also a positive sign that the utility arena is regaining its former strength.

How to light the fire
Again, some of the best opportunities for investors to gain broad exposure to this sector can be found in the ETF world. My favorite ETF in the group is the Utilities Select Sector SPDR (AMEX:XLU). This fund, which tracks the utility stocks in the S&P 500 index, has a favorable 3.38% yield and, at just 0.28%, the lowest expense ratio of all diversified utility ETFs. The index covers a broad range of holdings that represent the sector very well.

Second in the running is the iShares Dow Jones U.S. Utilities (AMEX:IDU). This fund should yield a little over 3.1% going forward, and is also a solid offering (the Dow index is very similar to that of the S&P). However, its 0.60% expense ratio, more than twice that of the SPDR, makes it less desirable.

On the flip side, I would advise readers to avoid the Utilities HOLDR Trust (AMEX:UTH) offered by Merrill Lynch. This ETF has a less favorable yield (about 2.8%) and hasn't performed as well due to some trouble with a few of its main holdings. The timing of the fund's launch was rather unfortunate, basically coming to market just before the Enron fiasco and as a boom/bust economy nearly brought the utility industry to its knees.

Even worse, as I discuss in the special report, HOLDRs are Unit Investment Trusts (UITs), so the investments are fixed and not actively managed. That means a lousy investment will only be removed from the fund if it goes bankrupt or is acquired by another company. HOLDRs can be exchanged for the actual securities that make up the fund for a modest fee, but that benefit isn't enough to offset the drawbacks of this ETF when there are better alternatives readily available.

Overall, the SPDR ETF is the best choice for most investors. This fund should allow you the flexibility to add broad utility exposure to your portfolio without sacrificing active management or the power of the payout.

The Foolish bottom line
Select ETFs can be an excellent supplement to the specific recommendations that we provide each month in Motley Fool Income Investor, and I encourage you to take advantage of their low costs and instant diversification benefits.

Since you must pay a commission when buying and selling, however, remember that these benefits can be overcome by additional trading costs in the case of investors who choose to dollar-cost average or build their positions consistently over time.

Mathew Emmert likes his utility picks, but hates getting a jolt of static electricity. He is the editor and chief analyst of our dividend-focused newsletter, Motley Fool Income Investor. He doesn't own any of the investments mentioned in this article, but the Fool does have an ironcladdisclosure policy.