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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

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, 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

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. 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) - Get AllianzGI NFJ Small Cap Value A Report

, which lost 26.5% in 2008, outperforming the

S&P 500

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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.

A diehard value investor, Allianz portfolio manager Paul Magnuson takes a variety of steps to limit risk. While his holdings have below-average price-to-earnings ratios, he avoids troubled shares. The fund considers only profitable companies with healthy balance sheets.

For extra protection, Magnuson stays broadly diversified, never putting more than 1.5% of his assets in any one stock. "A lot of fine managers have destroyed their performances by falling in love with a few stocks and betting too much on them," he says.

The fund holds stocks in each major industry, but Magnuson doesn't match the benchmark's weightings. Because few technology and health companies pay dividends, he underweights those sectors. The fund currently has 10% of its assets in utilities, a category that includes many dividend payers. A longtime utility holding is

AGL Resources


, an Atlanta-based gas provider that has a dividend yield of 5.4%.

Another low-risk choice is Royce Total Return. While Royce Funds offers a variety of small value funds, Royce Total Return is designed to be one of the steadiest. During the downturns of the past decade, the fund has suffered 58% of the losses recorded by the Russell 2000. In contrast, Royce's flagship

Pennsylvania Mutual

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, which holds dividend and nondividend-paying stocks, has suffered 70% of the losses faced by the benchmark.

During bull markets, Royce Total Return has sometimes lagged. Still, a strong showing in down markets has more than compensated for weak periods and enabled the fund to return 6.2% annually during the past 10 years.

Like the Allianz fund, Royce Total Return stays broadly diversified. The fund holds 400 dividend stocks, rarely putting more than 1% of assets in any one name. Portfolio manager Charles Royce favors companies with strong balance sheets and the ability to survive economic downturns. A favorite position is

Lincoln Electric Holdings

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, a maker of welding equipment that yields 2.5%.

Index-fund investors may prefer WisdomTree SmallCap Dividend, an exchange-traded fund that outdid the Russell 2000 by more than 5 percentage points in 2008. WisdomTree tracks a fundamental index of dividend stocks. According to this system, the ETF puts more of its assets into stocks that distribute greater total dividends. This is different from benchmarks, such as the S&P 500, which are weighted according to market capitalization. In an S&P index fund, stocks with bigger market capitalizations account for a greater percentage of assets.

Siracusano of WisdomTree says the company's dividend-oriented approach can be effective in foreign as well as domestic markets. Last year,

WisdomTree International SmallCap Dividend

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outdid the MSCI EAFE Small Cap Index by 2 percentage points.

WisdomTree Emerging Markets SmallCap Dividend

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topped the MSCI Emerging Markets SmallCap Index by more than 11 percentage points.

In a year when nearly all equity funds were clobbered, shareholders may have seen little reason to cheer WisdomTree's victory margin. But by sticking with dividend funds that excel in downturns, patient investors may achieve stellar long-term returns.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.