Dividend-paying stocks are compelling to investors for many reasons. They tend to be less volatile as a group. They provide a real cash return right away. And they can also reflect management's long-range visibility on profits and show its commitment to partnering with shareholders.

Back in 2006, WisdomTree Investments began weighting some of its equity exchange-traded funds not by each company's market value (as was the traditional indexing approach, popularized by Vanguard), but rather by total dividends paid. WisdomTree's rationale made some sense -- at least in theory.

Indeed, the group supported this theory by back-testing the strategy from 1964 to 2005. It found that not only did the portfolios exhibit lower volatility, but also that "four of the six WisdomTree Domestic Dividend Indexes generated greater price appreciation than the S&P 500 Index, even without the reinvestment of dividends."

Unfortunately, this dividend-weighted theory rested on one enormous assumption: The dividend-paying environment would continue to behave roughly the same way it had for that 41-year testing period.

Oops
As we're all now well aware, the dividend landscape has dramatically changed. The past two years have been the worst stretch for dividend investors in modern history. Sixty-two S&P 500 companies slashed their payouts some $40.6 billion in 2008 alone.

So far in 2009, 78 S&P 500 companies have cut their dividends, eliminating an additional $48 billion in annual payouts. Included in this group were SunTrust Bank (NYSE: STI), Steel Dynamics (Nasdaq: STLD), and Biovail (NYSE: BVF). All told, Standard & Poor's expects S&P 500 dividends to decline some 21% this year.

Needless to say, these massive dividend cuts have hurt WisdomTree's dividend-weighted strategy. As of Nov. 30, none of the six domestic dividend exchange-traded funds had outperformed the S&P 500 since their respective inception dates.

In fact, the worst-performing WisdomTree domestic dividend ETF has been the High-Yielding Equity Fund (DHS) -- or, as it was curiously but unsurprisingly renamed in March, the Equity Income Index. Whatever name it goes by, this dividend-weighted ETF is down 25% since its inception in 2006, much worse than the 5% lost by the S&P over the same period.

The wide underperformance of the ETF is largely a result of its dividend-weighted design, which aims to "reflect the proportionate share of the aggregate cash dividends each component company is projected to pay in the coming year, based on the most recently declared dividend per share." In other words, if Company A is expected to pay $500 in cash dividends next year, it should have a larger weight in the index than Company B, which is expected to pay $250.

Handcuffed
Under normal circumstances, that sounds like a nice way to generate extra dividend income and stack your bets behind strong companies. This year, though, has been anything but normal. The higher-yielding stocks have faced the greatest pressure on their dividends.

To illustrate this problem, as of Dec. 31, 2008, the High-Yielding Equity index's top holdings were:

Company

% of ETF Assets

Current Dividend Status*

General Electric

8.38%

Cut from $0.31 to $0.10

Bank of America

7.31%

Cut from $0.32 to $0.01

AT&T

6.98%

Raised from $0.40 to $0.41

Pfizer

6.30%

Cut from $0.32 to $0.16

JPMorgan Chase

5.74%

Cut from $0.38 to $0.05

Verizon

4.01%

Raised to $0.48

Philip Morris International

3.86%

Raised to $0.58

Wells Fargo

3.41%

Cut from $0.34 to $0.05

Merck

2.68%

Remains at $0.38

US Bancorp

1.95%

Cut from $0.42 to $0.05

*Dividend per share per quarter.

Adding insult to injury, the ETF only rebalances once annually, rendering it effectively helpless in a rapidly changing dividend environment. As dividend-dependent investors flocked out of stocks with dramatically lower payouts, this ETF has had to sit and grind it out. All 10 of these stocks remain in the ETF's top 11 holdings, despite the massive dividend cuts.

This ETF also continues to hold a number of other stocks that have cut their dividend, including Dow Chemical (NYSE: DOW), BB&T (NYSE: BBT), Alcoa (NYSE: AA), and International Paper (NYSE: IP). The flaws of the model are becoming more apparent with each successive dividend payout from the fund, which have naturally fallen sharply in the past 12 months.

A better way
For investors seeking to benefit from the advantages of dividend-paying stocks, the WisdomTree Equity Income ETF is one investment to avoid. With dividends being slashed left and right in this market, selectivity is essential, leaving mechanical strategies like this one at a major disadvantage. Among other things, savvy dividend investors will want to look for companies with solid balance sheets, a history of increasing dividend payouts, and plenty of free cash flow to cover the payments.

One company that fits this bill is PepsiCo -- which our Motley Fool Income Investor team has classified as a "Buy First" stock. At present, Income Investor picks yield 4.2% on average.

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This article was originally published March 5, 2009. It has been updated.

Fool analyst Todd Wenning congratulates Miami University (Ohio) on its bicentennial year. He owns shares of Philip Morris International, a Motley Fool Global Gains pick, but of no other company mentioned. Pfizer is an Inside Value pick. The Fool has a disclosure policy that tells it like it is.