The sidewalks are sizzling. The subways are steamy. The market is wilting. The dog days of summer are once again upon us. Time to see how the dogs of the Dow, and their mutual fund masters, are handling the heat.

For those unfamiliar with the concept, the dogs of the Dow are not members of an index tracking pet stocks but rather an investment strategy that advocates buying the 10 Dow Jones Industrial Average stocks with the highest dividend yields. Adherents to the dogs' philosophy believe these beaten-down stocks -- remember, yield moves inversely to price -- are undervalued and due to rally.

Typically, dog investors readjust their portfolios at the beginning of each calendar year. The daily progress of the dogs can be tracked on Web sites such as DogsoftheDow.com. The 2004 list includes Altria ( MO), SBC Communications ( SBC), General Motors ( GM), J.P. Morgan Chase ( JPM), Merck ( MRK), DuPont ( DD), Citigroup ( C), Verizon ( VZ), General Electric ( GE) and Pfizer ( PFE).

The strategy was first popularized by Michael O'Higgins in his book Beating the Dow , published in 1991. O'Higgins showed that over the 17-year period from 1973 to 1989, his dogs strategy averaged a return of 17.9% annually, compared with 11.1% for the 30 stocks in the Dow.

More recently, during the tech bubble of the late 1990s, the value-based dogs remained positive, though they lagged behind the returns of the S&P 500 ( SPX), which favored growth stocks. When growth stocks went decidedly out of favor during the ensuing bear market, the dogs behaved magnificently, outperforming the S&P by 15.6 percentage points in 2000, 7 points in 2001 and 13.2 points in 2002.

So far this year, the dogs have been barking up the wrong tree. As of July 29, the year-to-date return for the dogs is a negative 5.9%, not including dividends, compared with a loss of 0.9% for the entire 30-member Dow. The S&P is up just under 3% thus far this year. Still, that's not to say these stocks aren't worth another look.

Mutual Fund Dog Owners

Investing in the dogs is a relatively straightforward proposition for retail investors. Those who prefer to invest in the dogs through a mutual fund, however, can choose from one of three funds, though none of the funds invests its assets entirely in the 10 dog stocks.

The $21 million ( HBFBX) Hennessy Balanced fund puts 50% of its assets in the dogs and the other half in one-year Treasury bills, while the $91 million ( HDOGX) Hennessy Total Return fund has a 75%/25% dogs-to-T-bills ratio. According to fund-tracker Morningstar, the funds are down 1.62% and 0.49% this year (see chart below).

Neil Hennessy, portfolio manager for both funds, says investors should know that there is more to the dogs strategy than just performance, especially in the current tax environment.

"The yield on the dogs is 4.15% and that's for one year," says Hennessy. "That's tough to beat when you compare it to the five-year Treasury, which is yielding 4.15%, or even the 10-year Treasury at 4.33%. Plus, under the new tax laws dividend income is only taxed at 15%, not 40%."

Jay Wong, co-portfolio manager for the $48 million ( PDOGX) Payden Growth and Income fund, which uses the dogs strategy for 50% of its portfolio, agrees that the new tax advantages on dividends are being overlooked by investors.

"A lot of investors still have not fully appreciated the impact of the dividend tax cuts," says Wong. "On an after-tax basis it makes a big difference to your total return."

Furthermore, Wong says that unlike bonds, a dogs strategy offers investors the potential for capital appreciation potential with some high-quality value stocks. "You don't have the potential to make 10% to 15% equity-size returns in Treasuries," says Wong. "And from a style perspective, value continues to outperform growth."

Hot Diggity!
Dogs of the Dow Funds
Fund/Index Ticker YTD % Annual Returns % Expense Ratio %
2004 2003 2002
Hennessy Total Return HDOGX -0.49 2.3 22.6 -8.7 1.27
Hennessy Balanced HBFBX -1.62 0.2 12.4 -4.6 1.41
Payden Growth & Income Fund PDOGX -0.24 9.6 21.1 -14.1 0.8
S&P 500 -- 2.76 10.9 28.7 -21.5
Source: Morningstar (returns through Aug. 1).

Of course, the simplicity of the dogs strategy makes you wonder whether it's necessary to surrender any of that dividend yield or potential capital appreciation to a mutual fund manager. After all, there are just 10 stocks involved and there is little if any research necessary since the members of the group can easily be found on the Internet.

The two Hennessy funds charge slightly below the Morningstar average of 1.5%, while the Payden fund charges 0.80% to mix individual dogs with low-priced, index exchange-traded funds.

One explanation as to why investors might choose dog funds over buying and rolling over the individual stocks on their own is that they might lack the discipline to switch the member stocks on an annual basis. And as Neil Hennessy explains, "having a discipline is better than having no discipline at all."

"It's a contrarian investment style," says Hennessy. "But these companies have been around for a long time and will be around for a lot longer."

And if they do well in these dog days of summer, these funds just might become a shareholder's best friend.

To view Gregg Greenberg's video take on this subject, click here for StreetWatch.

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