Royce's, WisdomTree's Secret Fund Formula

Many large-cap funds hold dividend-paying stocks to protect against losses in downturns, but few small-cap funds focus on dividends. Portfolio managers prefer small companies that reinvest in their businesses instead of distributing cash to shareholders.

A handful of small-cap funds take a different approach, only buying dividend-paying stocks. During the meltdown of the past year, the dividend strategy proved rewarding, enabling those funds to outdo their benchmarks.

One proponent of dividend investing is Jack Fockler, a managing director at Royce Funds who oversees Royce Total Return(RYTRX Quote), a small-cap dividend specialist. "Dividend stocks tend to outperform in flat and down markets," says Fockler.

While dividends can boost large stocks, regular payouts can be especially important for investors in small stocks, says Luciano Siracusano, research director of WisdomTree Asset Management, which runs WisdomTree SmallCap Dividend Fund(DES Quote). Many nondividend-paying small stocks are shaky businesses with no profits, Siracusano says. In contrast, small companies that can afford to pay dividends tend to be profitable. Because they generally have solid cash flow, dividend stocks can be relatively resilient.

During periods when capital gains are scarce, dividend stocks can be particularly appealing because of their steady yields. Plenty of small caps currently yield more than 3%, a rich payout at a time when money markets yield less than 1%.

Investors seeking a steady dividend fund should consider Allianz NFJ Small-Cap Value(PCVAX Quote), which lost 26.5% in 2008, outperforming the S&P 500 by more than 10 percentage points and beating the Russell 2000 small-cap index by 7 points. This is not the first time that Allianz outperformed in a down market. When the S&P 500 lost money in 2000 and 2001, the fund stayed in the black. During the past 10 years, Allianz has returned 8.4% annually, 9.8 percentage points better than the S&P 500.