Sometimes, when you have a good idea at exactly the wrong time, you can never recover from your bad luck. But for an interesting set of exchange-traded funds (ETFs) that focus on dividend-paying stocks, the troubles of the past year and a half probably won't prove fatal.

The dividend approach
In 2006, WisdomTree came out with exchange-traded funds that used a somewhat novel approach. Rather than tracking a market-cap-weighted index, these ETFs would use a dividend-weighted model, where each component received a weighting based on the amount of dividends it expected to pay out over the coming year. Analysis of backtest data from 1964 to 2006 by the fund company showed that such a strategy would have produced above-average results.

For instance, when you look at the WisdomTree LargeCap Dividend index, you notice some of the same big companies you find in the S&P 500:

LargeCap Dividend Index Top 5 Holdings

Weight in Index

Rank in S&P 500

Weight in S&P 500

General Electric (NYSE:GE)

5.02%

6

1.87%

AT&T (NYSE:T)

3.89%

4

1.90%

Bank of America (NYSE:BAC)

3.84%

17

1.10%

ExxonMobil (NYSE:XOM)

3.41%

1

4.32%

Pfizer (NYSE:PFE)

3.22%

14

1.21%

Source: WisdomTree, IndexArb.com. Weights as of May 7.

Looking more closely, there's plenty of overlap between the two indexes. After all, the bigger a company is, the more cash it can pay out in dividends, so you'll expect to see some large companies near the top of the dividend index list.

But there are a couple of areas where the dividend index portfolio differs greatly from the S&P:

  • By definition, the dividend index leaves out stocks that don't pay dividends. That includes some huge companies, including Berkshire Hathaway, Apple (NASDAQ:AAPL), and Google (NASDAQ:GOOG).
  • On the other hand, financial stocks, many of which have seen their market caps plummet during the bear market, have much greater representation in the dividend index.

That exposure to financials is largely behind the losses in dividend ETFs over the past couple of years. For instance, the WisdomTree LargeCap Dividend ETF (DLN) lost 36% last year, and is down another 4.5% so far this year.

Moreover, because the index only gets recalculated once per year, it takes time for dividend cuts to work their way through the system. Obviously, since B of A, Pfizer, and many other big companies have cut their dividends dramatically in recent months, they won't show up among the top dividend index members next year. Until then, though, the ETF will stay invested in those companies.

Avoiding whipsaws
As painful as that lag time may seem, it also may bring some benefits to shareholders. While some dividend cuts precede the imminent failure of a business, others represent a positive step by corporate managers to conserve cash and improve future prospects. If an ETF has to blindly sell right away, it can end up dumping shares at the worst possible time and missing out on the ensuing recovery.

For instance, JPMorgan Chase cut its dividend on Feb. 23. By the end of trading that day, the company's share price was below $20. Now, after the bank's prospects have improved, shares have risen above $35. The ETF's methodology allowed fund shareholders to benefit from that bounce.

A brand-new day
Eventually, though, dividend ETFs will get rid of those companies that no longer belong among their ranks. When that happens, the fund can essentially start over, with the expectation that this once-in-a-lifetime confluence of circumstances hopefully won't repeat itself.

Given how powerful dividend-paying stocks can be in your portfolio, dividend ETFs aren't likely to stay down for long. Even though they've suffered a setback in the bear market storm, long-term investors can expect more reasonable returns in the future.

For more on being smart about dividend investing, read about:

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Fool contributor Dan Caplinger likes getting those dividend checks. He owns shares of Berkshire Hathaway and General Electric. Google is a Motley Fool Rule Breakers recommendation. Apple and Berkshire Hathaway are Motley Fool Stock Advisor selections. Berkshire Hathaway and Pfizer are Motley Fool Inside Value recommendations. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy keeps the lights on for you.