I am a Y1 teacher (currently on maternity leave) with a ds in Y1 at the school I teach in.
I would not worry too much about those sight words. Last year, we had exactly the same experience as you - ds not doing as well at reading as others in the class, but loving books, listening avidly to Raold Dahl chapter books/My Naughty Little Sister/Faraway Tree etc, and generally being brighter than his reading level indicated. He had the sight words sent home, but found them tedious. Being a full time working mum, I didn't push them, as I would rather spend the time we have doing things that we enjoy, so carried on doing the reading, reading our own books etc. As I teach Y1, I had the reassuring knowledge that Y1 is the key year for things "clicking" or falling into place for so many children, so decided I would worry about ds when we got to the end of Y1 if the situation was still the same. (He is also an August birthday, so that can play a part, particularly at this level.) Anyway, it has all come together for him this year, and as a previous poster says, he has shot along the reading scheme and is now one of the furthest along readers in his class, loves it, reads his chapter books by himself, has great expression and understanding of inference and implicit information, all of which I put down to the variety of books that we have read together outside school and chatted about, and my own particularly hammy acting style when reading .
I know that there is an awful lot of anxiety around this kind of stuff with little ones, and I (personally) don't agree with the certificate for being able to read the HFW (I can read a physics text book, doesn't mean I even vaguely understand it) but then, that WILL work with some children, and schools do have to approach things in different ways to accomodate as much of the variety of learning styles as they can.
IMHO (please don't take this the wrong way), the worst thing that you can do is become hung up and stressed about all of this; children are well able to pick up these vibes, and the most anxious children I have taught generally seem to have parents who are anxious also. It sounds like you have been doing lots of lovely things, and making sure that reading isn't "something for school" but something for life, and that's a great gift to give your dd.