Recently, I weighed in on one of the most highly-debated topics within the world of finance.

Sure, it may not carry the same weight as Ford vs. Chevy or Yankees vs. Red Sox among most Americans. But you’d be surprised by the level of intensity it stirs up among market pros.

I’m talking about whether investors should invest in actively-managed or passive funds.

My intent with that piece wasn’t to stir up debate. On the contrary, as I pointed out, there are some good arguments on both sides of the issue. And ultimately, since everyone’s situation is different, it really comes down to the individual and their preferences.

But today, I want to talk about a group of funds that bring the best of both worlds together. They combine the inexpensive cost, transparency, and tax efficiency of an index fund with the discriminating taste of an active manager.

Make no mistake, I still believe in taking charge of your own portfolio in the form of individual picks — after all, I wouldn’t be running my premium service, High-Yield Investing, if I didn’t. But this hybrid model just might be something we can all agree on. They’re growing increasingly popular, and I think they deserve serious consideration for the core of any savvy investor’s portfolio.

The “Factor” Fund Is Born

Traditional index funds are great. But they must adhere to strict construction and rebalancing methodologies. No attempt is made to add “good” stocks or avoid “bad” ones. That’s part of the tradeoff when you “buy the dartboard” instead of throwing darts individually.

But along the way, somebody cleverly noticed something. Bigger companies will always influence the moves of these funds (and their underlying indices) because they are weighted by market cap. And they wondered to themselves… Is this bias warranted? Is there definitive proof that large stocks are somehow better than smaller ones?

Turns out, not really. In fact, multiple studies indicate otherwise. So rather than give the biggest weight to the largest companies (which may be overvalued), they decided to take the same stocks in the S&P 500 Index and simply give them all the same voice.

And just like that, the equal-weighted S&P index fund was born. The Invesco S&P 500 Equal Weight ETF has handily outrun the standard S&P 500 over the past 20 years. All from changing just one tiny “factor” in an index…

Choices For Every Flavor Of Investing

Well, you can probably guess what happened next. All of a sudden, more smart people began experimenting by taking a basic universe of stocks and creating a custom index. Those indices would be comprised of companies that exhibit certain attractive factors that are historically correlated with superior total returns over time.

One of the most famous indicators, of course, is dividend yield. We know from studies that dividend payers outperform non-payers by a substantial margin over the long term. So the natural outcome was both logical and inevitable: just build an index isolating this one trait – or “factor.” Sure enough, many institutional managers (endowments, pension funds, etc.) did just that.

But dividend yield isn’t the only reliable predictor of above-average market gains. In the 1990s, famed market researchers Eugene Fama and Kenneth French conclusively showed that undervalued stocks (as measured by Price/Book) also had a long-term edge.

There are other factors associated with superior risk-adjusted returns. They include aggressive stock buybacks and meaningful debt reduction, among others. We don’t need to delve into these studies’ finer points other than to say they are supported by reams of academic research.

I’ve been in this business a long time, and I accept those conclusions. Stock market winners do indeed often share certain traits. And these “factor” funds can be harnessed to deliver superior risk-adjusted returns – or “smart beta.”

Why Factor Funds Deserve A Serious Look

In some respects, factor funds are just like ordinary ETFs. They are still tethered to a fixed index. But with one crucial difference… These indexes are built to be better. They use objective, rules-based screens to target stocks endowed with specific qualities (high yields, low debt, etc.). These fundamental metrics can also determine the weighting of individual components.

It’s the intersection of active and passive investing.

One of my favorite factor funds is the Invesco S&P 500 High Dividend Low Volatility ETF (NYSE: SPHD). This offering is a multi-factor fund targeting stocks that exhibit two different traits: low volatility and generous dividend yields.

It’s the perfect solution for the investor who doesn’t like that queasy feeling you get when the market throws a tantrum. Due to the nature of the fund’s composition, it probably won’t outperform the S&P 500 in a raging bull market. But when volatility rears its ugly head and sends the broader market down sharply, this fund has a proven track record of holding up better.

I won’t get into all the details on how the index is constructed right now. But SPHD has performed better (on a risk-adjusted basis) than most plain vanilla index funds and is far less expensive than most active funds.

If you want a smoother ride when the market acts up, consider SPHD. And overall, if you’re looking for a little more sophistication (better returns, low fees, etc.) out of your “core” holdings, then I strongly suggest looking into these “smart” funds as an alternative to more traditional funds.

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