A fund based on a perfectly reasonable strategy gorged on financial stocks. The result wasn't pretty. By Elizabeth Leary, Contributing Editor June 1, 2009 The case for owning high-yielding stocks during hard times runs something like this: Consistent dividend payers are, by definition, financially stable or they wouldn't be able to sustain their payouts. Plus, owning high yielders means you get paid while you wait for better times to return. But over the past year and a half, the lure of dividends proved to be a siren song. The main problem: Financial stocks represented a disproportionately large percentage of big dividend payers.Nothing better exemplifies the pitfalls of a payout-oriented strategy than iShares Dow Jones Select Dividend Index (symbol DVY). The exchange-traded fund tracks an index 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 financials from the outset. At its inception, in late 2003, the fund allocated 43% of its assets to financial stocks. Going into 2008, by which time storm clouds had already gathered over the financial sector, the allocation had risen to 49%. That outsize stake in financials played a major role in the fund's crummy performance of late; it lost 46% over the 12 months ended April 9, trailing Standard & Poor's 500-stock index by six percentage points. 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 gives a company the boot immediately if the firm 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 a penny in April 2008. And Dow Jones promptly expelled JPMorgan Chase and Wells Fargo from the index after they slashed their dividends in early 2009. All told, Dow Jones has expunged 34 financial stocks from the Select Dividend index since April 2008. Advertisement The iShares ETF isn't the only dividend-oriented index fund to flounder. Over the past year through March 31, actively managed dividend funds lost 37%, while those that track indexes (including ETFs) lost 43%. Among the better-performing actively managed funds, American Century Equity Income (TWEIX) lost just 23% over that period. 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; that prevented 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 taken the major hit," Kay says. Dow Jones recently changed its methodology; it will now overhaul the entire Select Dividend index quarterly, meaning the iShares ETF will now more closely approximate its actively managed rivals. Still, investors would do better with actively managed alternatives, such as the American Century fund or Vanguard Dividend Growth (VDIGX), which looks for companies with the wherewithal to raise their dividends in the future.