A fund based on a perfectly reasonable strategy performed miserably over the past year because it gorged on financial stocks. By Elizabeth Leary, Contributing Editor March 24, 2009 The traditional case for owning dividend-paying stocks during hard times runs something like this: Consistent dividend-payers are, by necessity, financially stable or they wouldn't be able to sustain their payouts. Plus, by owning a high-yielding stock, you get paid to wait until better times return. But over the past year and a half, the lure of dividends proved to be a siren song -- as investors discovered, to their chagrin. The main problem: Financial stocks represented a disproportionate percentage of big dividend payers, and that sector has imploded during the current economic crisis. Nothing has better exemplified the pitfalls of a payout-oriented strategy than iShares Dow Jones Select Dividend Index (symbol DVY). The exchange-traded fund tracks an index that invests in the stocks of the 100 highest-yielding U.S. companies that have maintained or boosted their dividend over the past five years. In addition, eligible companies cannot have paid out more than 60% of their profits, on average, over the previous five years. DVY, which we labeled the best ETF in our November 2006 "Best of Everything" issue, dived headfirst into financial stocks from the outset. At its inception, in late 2003, the fund allocated 43% of its assets to financial stocks; Bank of America topped the list with a 5% weighting. Advertisement Going into 2008, by which time storm clouds had already gathered over the financial sector, that allocation had risen to 49%. The outsized stake in financials played a major role in the fund's crummy performance of late -- it lost 44% over the 12 months ending March 18, trailing Standard & Poor's 500-stock index by five percentage points. Changing composition. Little by little, Dow Jones, which determines the Select Dividend index's components, is weeding out the stinky financials. Although Dow Jones normally overhauls the index's components once a year, it immediately gives a company the boot if it drastically cuts or eliminates its dividend. That's precisely what it did to Washington Mutual when the bank holding company slashed its dividend from 15 cents per share to 1 cent in April 2008. And Dow Jones promptly expelled JPMorgan Chase and Wells Fargo from the index after the banking giants announced 87% and 85% dividend cuts, respectively, in early 2009. Financial stocks haven't been the only troublemakers. International Paper got the boot in March after announcing a 90% dividend reduction just a few months after being added to the index. Companies as diverse as General Electric, Pfizer and Dow Chemical have also sliced their payouts lately. Almost "any company paying dividends is cutting dividends," says Mariela Jobson, a portfolio manager for iShares. The iShares ETF isn't the only dividend-oriented fund to flounder in this market. Over the past year through March 18, actively managed dividend funds lost 36%, while those (including ETFs) that track indexes lost 41%. "The ETF armor is failing, a little bit," says Lipper analyst Tom Roseen. Advertisement Why did the managed funds hold up better? Morningstar analyst Bradley Kay says that some active managers match their sector allocations to a broad market index, preventing them from gorging on financial stocks. Plus, active managers can trade in anticipation of news, while the index funds "swap out of these stocks after they've already taken the major hit," Kay says. Jobson, the iShares manager, says Dow Jones recently changed its methodology; it will now overhaul the entire Select Dividend index quarterly rather than annually. The move means that from now on, the iShares ETF will more closely approximate its actively managed rivals. At its March 18 closing price of $31.44, it yields 6.8%.