“How’s the market doing today?”

I get that question a lot. And my standard response is usually along the lines of “which market?” I’m not trying to be cute. I could be covering Brazilian iron ore exports one week and municipal bonds the next. Trust me, there are a lot of markets.

Of course, most people are asking about domestic blue-chip stocks, which means the S&P 500. There is a colossal amount of money tied to this popular benchmark: a couple trillion at least. The SPDR S&P ETF (NYSE: SPY) has attracted $540 billion in assets by itself.

Within that pool are college endowment proceeds, pension fund contributions, rainy day savings accounts, and a good chunk of your next-door neighbor’s 401(K). If you’re reading this, odds are good your own net worth is partially tied to the performance of the S&P 500.

Financial advisors, market pundits, and your Uncle Saul will all tell you that investing in a low-cost index fund is a no-brainer. And for good reason. About 65% of active large-cap funds failed to keep pace with the overall market last year.

Still, that means more than one-in-three managed to outperform. We’re talking about thousands of overachievers — not exactly finding a needle in a haystack.

These percentages vary widely from year to year. Only 14% of active funds outran the S&P in 2014, while more than half (60%) did so in 2009. As a rule, stock pickers tend to do better in turbulent conditions that spawn more pricing dislocations.

But anybody can top the market for a year or two. The real challenge is to consistently stay ahead for a longer time frame of 10+ years. That’s a much smaller sample size. Which is why even Warren Buffett advises most investors to stick with simple, low-cost index funds. Peter Lynch too. Yes, the same guy that racked up a market-crushing annualized gain of 29% during his legendary career once said to forget about throwing darts and just “buy the whole dartboard.”

But do you get the entire board? That’s the real question. There may technically be 500 members in the S&P, but the ten largest constituents of this top-heavy barometer have a louder voice than the bottom 300 combined.

The bigger they get, the more power they wield. At times, a small handful of tech stocks account for a disproportionate 90% of the index’s total return. It’s a formula that systematically puts tomorrow’s greatest influence on yesterday’s biggest gainers.

And we’ve just seen what can happen when sentiment turns sour for highfliers like Apple (NSDQ: AAPL) and Nvidia (NSDQ: NVDA).

The Best of Both Worlds
I’m not here to debate the merits of active vs passive investing. If you’re interested, there are terabytes of available reading material on the subject. For me, it often boils down to a simple golf analogy.

If somebody guaranteed you a system that would let you shoot par on every hole, would you take it? There are worse outcomes. Or would you rather put in extra work to potentially do a little better than the field… and score the occasional birdie?

Personally, I lean towards the latter.

Don’t get me wrong, there are times when a straightforward index tracker makes a lot of sense. If the goal is simply to gain low-cost exposure to a specific sliver of the market (such as healthcare), then the iShares U.S. Healthcare (NYSE: IYH) ETF fits the bill. That’s particularly true for hands-off investors without the time or inclination to stay on top of their holdings.

But other times I am inclined to hand the reins to a seasoned active manager with a proven track record. They can be worth every penny.

Take the Pimco Dynamic Income Fund (NYSE: PDI). It’s managed by Daniel Ivascyn, who has spent three decades in these trenches. During that time, he has been named Morningstar Fixed Income Manager of the Year (2013) and was inducted into the Fixed Income Analysts Society Hall of Fame (2019).

Ivascyn is backed by a team of seasoned credit analysts and researchers trained to sniff out troubled balance sheets and spot opportunities. PDI is free to explore anywhere and holds everything from mortgage-backed bonds to emerging market sovereign debt. Management can also shift assets around in response to changing macro conditions. If rain is coming, they can move for higher ground.

By contrast, passive funds are handcuffed to one specific area and must blindly mirror the index (even securities with obvious flaws). It’s no fluke that PDI outran more than 90% of its category rivals last year.

I generally prefer active management in less liquid market terrain where there are more pricing inefficiencies to exploit. But as I hinted in the title, recent innovations have blended the lines, combining elements of both strategies. Picture the flexibility of a mutual fund with the low expense and tax efficiency of an ETF.

This hybrid model just might be something we can all agree on.

The Logic of “Smart Beta”
Traditional index funds must adhere to strict construction and rebalancing methodologies. No attempt is made to favor “good” stocks/bonds or avoid “bad” ones. The only real trait that gets any consideration is size. Most indexes are weighted by market cap, so bigger securities automatically exert more pull than smaller ones.

Is this bias warranted? Is there definitive proof that a $500 billion company has more upside potential than a $50 billion company? Not really. In fact, multiple studies indicate otherwise.

So it’s a bit surprising that it took this long for money managers to start designing custom-built indexes that prioritize traits other than sheer market girth. After all, there are reams of academic research that have identified common telltale characteristics of stock market winners. For example, businesses actively eliminating debt or engaging in meaningful share repurchases often have a measurable edge.

We don’t need to delve into the finer points of these studies (trust me, they make for dry reading). Suffice it to say that these “factors” can be harnessed in a way to deliver superior risk-adjusted returns.

Factor-based ETFs are still tethered to a fixed index. But with one crucial difference. These aren’t plain-vanilla indexes. They use objective, rules-based screens to target stocks endowed with specific qualities.

Growth-oriented funds might show preference to businesses with the fastest sales growth per share over the past three years. Or stocks with the strongest momentum. Value-centric funds could look for inexpensive stocks with superior returns on equity and low price/book and price/cash flow ratios.

Just about any quantitative fundamental screening criteria can be applied to determine index construction and weighting. This is the intersection of active and passive investing. These funds give investors a way to precisely tilt their portfolio toward specific attributes that can help lower volatility and optimize returns.

As you might expect, big players like Vanguard and Fidelity have gotten into the game. At this point, more than 1,000 smart-beta ETFs have been launched, collecting $1.5 trillion in assets.

Given recent market turbulence and global economic uncertainty, this might be a good time to explore the Invesco S&P 500 High Dividend Low Volatility ETF (NYSE: SPHD).

As you can guess from the name, this is a multi-factor fund targeting stocks that exhibit two desirable traits: low volatility and generous dividend yields. Here’s how the index is constructed.

Starting from an initial pool of all S&P 500 members, the 75 highest yielders advance to the next round and the bottom 425 are eliminated. From there, each candidate is put through a secondary screen and ranked by volatility. The 25 most volatile stocks are removed, leaving 50 finalists.

These constituents are weighted by yield (rather than market cap) but capped at 3% to ensure proper diversification.

The market’s highest yielders generally tend to be mature, well-established businesses, so there is an inherent bias toward defensive value stocks such as Verizon (NYSE: VZ) and Pfizer (NYSE: PFE). The volatility overlay reinforces that favoritism, reducing exposure to cyclical areas (such as industrials) and placing greater emphasis on sectors with steady cash flows.

SPHD imposes an annual fee of just 0.30%, a fraction of what its equity income category rivals charge. Don’t expect the fund to keep pace with racier rivals when the market is red-hot. But overall, it has proved its mettle, particularly during shakier macro conditions.

Through April 1, the fund chalked up a year-to-date gain of 5.0%, while the S&P suffered a -4.3% loss. Over the past 12 months, it has doubled the market by a score of 17.4% to 8.3%. Better still, it has done so with less volatility and a smoother ride.