Back in August of last year, I talked about a relatively new group of funds that have come to the marketplace recently. And due to their unique construction, it’s worth it for investors to investigate these funds and consider adding them as core portfolio positions.

I’m talking about “factor” investing – or “smart beta” funds.

I’m going to share the name of one of my favorites in just a second. But first, in order to understand what these funds are (and what they’re not) let’s recap what I said in my original piece:

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 outrun the standard S&P 500 over the past 15 years by about 60 basis points annually (9.8% to 9.2%).

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.

And just like that, “factor” funds were born.

As I mentioned in that piece, these funds (and their indices) are based on multiple factors that are supported by reams of academic research to deliver superior risk-adjusted returns. These “factors” could be anything from aggressive stock buybacks to meaningful debt reduction to dividend yield, and more.

I don’t want to get into the weeds of the methodology of these funds. As I’ve written repeatedly, stock market winners often do share certain traits. And these drivers can be harnessed in a way to deliver superior risk-adjusted returns – or “smart beta.”

So without further ado, let’s take a look at one of my favorites…

My Favorite “Smart Beta” Fund

If you could only pick one “smart beta” fund, you could do a lot worse than the Invesco S&P 500 High Dividend Low Volatility ETF (NYSE: SPHD).

As you might have guessed from the name, this offering is a multi-factor fund targeting stocks that exhibit two different 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. 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 IBM (NYSE: IBM). The volatility overlay reinforces that bias, reducing exposure to cyclical areas (such as industrials), and placing greater emphasis on sectors with steady cash flows.

Approximately 75% of the fund’s assets are sunk into five main groups: real estate, utilities, energy (mostly midstream), financials and consumer staples.

The index is reconstituted and rebalanced semi-annually, which minimizes risk even further. Because position sizes are weighted by dividend yield (and yields move inversely to share prices), the rebalancing process automatically forces the fund to withdraw assets from holdings that have appreciated the most and deposit into those that are less expensive.

SPHD has an annual fee of just 0.30%, a fraction of what most actively-managed dividend funds charge.

Not surprisingly, you’ll find a number of familiar names in the portfolio. The dividends from all these holdings support a monthly distribution of $0.15 per share.

That equates to a yield of 5.6% — nearly triple the market average.

Action to Take

The resultant sector weightings look quite a bit different than the Russell 1000 Index, as well as your run-of-the-mill large-cap value fund. There is far more exposure to utilities and real estate and very little representation from healthcare and technology. So don’t expect SPHD to keep pace with racier growth funds when the market is red-hot. But overall it has proved its mettle, particularly during shakier macro conditions.

The portfolio turnover is a bit higher than usual here, which could have tax implications. And I would like to see a screen for dividend sustainability (such as payout ratio). The portfolio should also benefit from rate loosening.

Still, SPHD has performed better than most plain vanilla index funds and is far less expensive than most active funds.

This fund deserves consideration as a core holding. But if you’re looking for the absolute best high-yielders the market has to offer, then you need to check out my premium newsletter service, High-Yield Investing. In each issue, we profile securities that pay yields of 5%, 7%, 9% and more. Most investors aren’t even aware these investments even exist, but they’re out there.

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