http://accs-net.com/hosts/faq.html#19

(6.) Why doesn't the Hosts file work with my proxy settings?

Some proxy servers can not be bypassed, unfortunately, and will not work with the Hosts file properly according to Microsoft. This is because of a bug in the programming of the way Hosts is handled by Windows. The work around for this is to add all the entries from your Hosts file into the exclusions section of your proxy settings in Internet Explorer. This would be very time consuming, and is not recommended. The other thing you can do is visit the GRC FAQ site and read the information about "nasties.reg." You can use this file to add many add servers to your Restricted Zone in IE, and if you do so you can then block cookies using the Restricted Zones settings and that will stop tracking from those servers. If you use Netscape, I don't currently have such a procedure available, because it does not use restricted zones."

I read elsewhere that WD "locks" the Hosts file. I guess I just don't understand how "hosts" works (and often doesn't, depending on configuration?). Forgive my ignorance.