Why “Smart” Funds Should Have A Place In The Core Of Your Portfolio

There are some big cultural divides among Americans: Ford vs. Chevy, Red Sox vs. Yankees, active versus passive management.

Okay, that last one might not be much of a conversation starter at your next dinner party. But among the investment community, this can be a divisive and hotly debated topic. On one side are the folks who insist it is folly to try to beat the market, so save yourself the trouble and invest in a low-cost index fund. In the opposite camp are those who believe it’s well worth the effort to seek out exceptional money managers that can deliver superior returns.

The preponderance of evidence would seem to support the indexers. The majority of large-cap funds (about 60%) failed to keep pace with the S&P 500 in 2020 (for the 11th year in a row). But that’s hardly an open-and-shut case.

It still means about 40% of the large-cap fund universe outperformed the market. And interestingly enough, only 46% of small-cap funds underperformed their benchmark. I should note that these figures vary widely from year to year. That would support the notion that active managers do better in volatile conditions.

It’s easier to find managers that beat the market for a year or two than those who consistently do so over the long-haul. But they are out there… Bill Miller famously steered the Legg Mason Value Trust to market-beating gains 15 years in a row through 2005.

Or how about Peter Lynch? The legendary money manager annihilated the market when he was at the helm of the Fidelity Magellan Fund (once the largest in the world), racking up annual returns of 29.2%. During his 13-year tenure ended in 1990, a $10,000 investment would have grown to $280,000.

This flummoxes proponents of the efficient market theory. They contend that stock prices adjust quickly and fully reflect the latest information available. That would mean stocks are always priced perfectly, so it’s impossible to achieve excess market returns.

I think this is utter nonsense. The fact is, the market is sometimes irrational, driving stocks well below (or above) what they’re really worth.

Active Or Passive: Which Path Is Best?

Skilled money managers can identify mispriced securities that are likely to outrun the crowd. Admittedly, these are the exceptions, not the rule. Even Buffett himself endorses passive index funds for some investors. So does Peter Lynch, who once said to forget about throwing darts and just “buy the whole dartboard.”

Having spent many years in this business, I fully believe that some active managers are well worth the added cost. It’s just a matter of finding them. Of course, active closed-end funds also have the freedom to use leverage and other tactics to boost portfolio yields.

Still, you’ll find a mix of both active and passive funds in my portfolio — and I wouldn’t be writing my premium newsletter, High-Yield Investing, if I didn’t believe in taking at least somewhat of an active approach.

Different situations call for different strategies. If the goal is simply to gain low-cost exposure to a specific sliver of the market, then a passive exchange-traded fund (ETF) may fit the bill just fine.

Other times, I am inclined to hand the reins to a seasoned active manager with a proven track record.

I am more inclined to use active management strategies for fixed income, because bonds are relatively illiquid, with more pricing inefficiencies to exploit. The same is true for emerging-market stocks. That’s why you’ll typically see a much greater percentage of active funds outperform in these asset classes.

The Best Of Both Worlds

My intent isn’t to stir up a debate. Instead, I want to call your attention to a relatively new group of funds that can offer the best of both worlds. They combine the inexpensive cost, transparency and tax efficiency of an index fund with the discriminating taste of an active manager.

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

As you know, traditional index funds must adhere to strict construction and rebalancing methodologies. No attempt is made to add “good” stocks or avoid “bad” ones. The only real trait that gets any consideration is size. Because they are weighted by market cap, bigger companies automatically exert more pull than smaller ones.

Is this bias warranted? Is there definitive proof that large stocks are somehow better than smaller ones? Not really. In fact, multiple studies indicate otherwise. So, somebody had a clever idea. Let’s take the same 500 stocks, but rather than give the greatest influence to the largest (which can also be the most overvalued), simply give them all the same voice. Voila! The equal-weighted S&P index fund was born.

It has handily outrun the standard S&P 500 over the past 15 years…

Let’s take this concept a little further. What if we start with the same basic universe of stocks, but then create a custom index whose membership is limited to companies that exhibit certain attractive traits? And by attractive, I mean quantitative features that have historically been 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 — supported by reams of academic research — associated with superior risk-adjusted returns. They include aggressive stock buybacks and meaningful debt reduction, among others. We don’t need to delve into the finer points of these studies; but I do accept their conclusion that stock market winners often share certain traits. These drivers can be harnessed in a way to deliver superior risk-adjusted returns – or “smart beta.”

The Takeaway

In some respects, these “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.

There are a number of choices in this realm for investors. One of my favorites, however, 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. Just look at how this fund has performed since the start of 2020, a period that includes the painful Covid-selloff…

I won’t get into all the details on how the index is constructed right now. But SPHD has performed better than most plain vanilla index funds and is far less expensive than most active funds. The portfolio should benefit from rate loosening. And I appreciate the effort to minimize volatility.

If you’re looking to get a little bit more out of your “core” funds, then I strongly suggest looking into these “smart” funds as a potential replacement.

P.S. My colleague J.R. Butts has been researching the “next investment frontier” in tech for the past few months. And he’s convinced this is the “next big thing”…

You may already know that Elon Musk is busy commercializing outer space with his company, SpaceX. Dozens of other companies are scrambling to win the race, too. But what’s barely getting any attention in the mainstream press is one of Musk’s “secret” projects that could be an absolute game-changer. And J.R. has discovered a unique “backdoor” way we can gain exposure before the crowd catches on…

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