Since its November 2003 launch, the iShares Dow Jones Select Dividend Index (DVY) has become one of the fastest-growing and most popular exchange-traded funds (ETFs) on the market. It's also the only ETF that invests exclusively in dividend-paying stocks. More specifically, the fund tracks the performance of the Dow Jones Dividend Index, which includes 50 of the highest-yielding firms in the broader Dow Jones U.S. Total Market Index.

Impressive Returns
Based on the fund's first two dividend payments in 2004, DVY pays an estimated $1.90 annual dividend, which equates to a yield of roughly +3.5%. Quarterly dividend payments have increased from an initial 29 cents in December 2003 to 49 cents in 2004. Since its inception in late 2003, the fund has returned a total of +13%. Meanwhile, the overall market has remained basically flat. The fund's low expense ratio of less than half a percentage point takes a very small bite out of its overall returns (which include dividend income plus share price appreciation).

The chart below shows DVY's performance relative to the S&P 500 (GSPC) over the course of the last year.

Bluest of the Blue Chip
Trading on the New York Stock Exchange, the fund's performance reflects the strength of its top holdings, including such American icons as Bank of America (BAC) and Altria Group (MO). Although the Dow Jones Select Dividend Index invests in some of the market's highest-yielding stocks, it takes more than a solid yield for a firm to qualify for inclusion in this prestigious index. As you may know, high yield isn't the same as high quality. To that end, the fund invests only in companies with proven track records of consistent dividend payments.

To be included in the underlying index, a company must exhibit a positive five-year dividend growth rate. Meanwhile, its dividend payout ratio (defined as the percentage of earnings used to pay dividends) must be no higher than 60% for the past five years. That guideline helps ensure that each of the fund's components pays dividends that are sustainable and are likely to keep growing in the future. Over the past year, DVY's component stocks have boosted their dividends by an average of +8%.

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Real estate investment trusts (REITs) are excluded from the fund because their dividends are considered less predictable than those of regular common stocks. Companies must also exhibit trading liquidity, with an average daily trading volume of at least 1.5 million shares. To maintain these strict standards, the index is rebalanced every year and each company's weighting is based on its annual dividend.

Not Without Risk
Because of its strict dividend requirements, the Dow Jones Select Dividend Index is somewhat lacking in diversification. Almost half of the fund's $2.6 billion in assets are in mid-cap companies, while only about a third are in large-cap stocks and the balance in small-caps.

When it comes to sector allocation, the fund is also heavily weighted in a few specific sectors. Almost half of DVY's assets are in financial services, mainly banks, while about 20% are in utilities. Although these sectors tend to be highly sensitive to interest rates, the fund's components have been stable dividend-payers for many years. No software, hardware, or media companies are included, and telecom only accounts for about 3% of the fund's assets.

Action To Take
With its focus on mid-cap financial and utility stocks, DVY could add variety as well as solid income and steady returns to an income-oriented portfolio. The fund is also attractively valued with a PE of about 14 based on trailing 12-month earnings. That compares favorably with the popular S&P 500 SPDR (SPY) fund, which tracks the broader market and sports a much higher PE of 17.

The table below displays some of the fund's key statistics:

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