Enhanced indexing
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Enhanced Indexing is a structured approach to index funds investing that builds on the basic principles of index fund construction with an emphasis on performance rather than market tracking. Like traditional index funds, enhanced index funds offer the advantages of low operating costs, low turnover, and diversification. The different approaches to enhanced indexing build on some of the key concepts of traditional indexing.
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[edit] Focus on Performance Instead of Tracking-Error
Traditional index managers try to simply replicate or "track" the market averages (whether up or down) - typically by replicate commercially available indexes that are supplied by the statistical bureaus like Standard & Poor's or The Frank Russell Company. In general, traditional index management is focused solely on tracking the index. Furthermore, the weights of the securities in the index are typically based on market capitalization or some modification of capitilization weighting (like using float instead of shares outstanding).
There are generally two types of enhanced index strategies. The first is often referred to as "enhanced cash". Enhanced cash managers use futures to replicate the index then they take the roughly 95% of the capital left after buying futures (with there inherent 20 to 1 leverage) and purchase fixed income securities. The key to performance in these strategies is that the yield on the fixed income strategies is greater than the yield that is priced into the futures contracts (for the leverage).
The other type of enhanced index strategy use stock selection as described below.
[edit] Enhanced Indexing Versus Active Management
In contrast to indexing, active management, tries to beat the market index through security selection and sometimes market timing as well. Many active portfolios have high turnover and higher fees than indexed approaches. As we have already discussed in the indexing section, however, many active funds and managers don't keep up with the index over the long-term, especially net of fees.
[edit] Enhanced Indexing As A Structured Approach
Enhanced indexing is a structured approach that utilizes innovative techniques to manage diversified market-wide or sector-wide portfolios. It is different from both traditional index investing and traditional active management (though it is closer to indexing than to active management), because it combines elements of each. Like traditional indexing, enhanced indexing emphasizes portfolio diversification, asset class exposures. It also tries to minimize transaction costs and turnover while trying to maximize tax-efficiency. Like active investing, however, enhanced indexing does emphasize returns and is willing to sacrifice tracking to get there. In summary, enhanced indexing allows latitude to intelligently construct proprietary or dynamic indices (rather than replicate static commercially available index models).
[edit] Differences Between Traditional and Enhanced Approaches to Index Fund Construction and Management
Enhanced indexing comes in a variety of flavors. Though specifics vary, some of the more common enhancement strategies include:
1. Index Construction Enhancements – Instead of relying on external indexes created by third parties like S&P or Dow Jones, enhanced indexes often use proprietary indexes. Alternatively they use dynamic rather than static indexes.
2. Exclusion Rules – By using additional filters, some enhanced indexes eliminate securities likely to reduce performance that would be otherwise included in traditional indices (e.g. companies with excessive debt or those in bankruptcy).
3. Trading Enhancements – Utilizing intelligent trading algorithms, some enhanced index funds create value through trading (e.g. by buying illiquid positions at a discount or by selling more patiently than traditional index funds).
4. Portfolio Construction Enhancements – Enhanced index funds sometimes implement hold ranges that reduce portfolio turnover by allowing funds to hold positions during buffer periods even after traditional sell signals are triggered.
5. Tax-Managed Strategies – Among the newest enhancements, tax-managed index funds manage buys and sells to minimize taxes. These tax-managed index funds can be superior to variable annuities for tax-efficient wealth creation.
[edit] Enhanced Index Fund Performance
The better enhanced indexing strategies have outperformed their traditional index counterparts by 1% to 3% per year or more. Since index funds can outperform some of the active funds by a similar margin over the long-term, enhanced indexing versus active investing can represent as difference of as much as 2% to 6% per year relative to the majority of active investing approaches. With compounding, a small annual different of as little as 2 to 3% really adds up - as illustrated by the following example. Let's say you start with a $1M portfolio in a world with no taxes. If the actively managed portfolio returns 8% over 30 years, the $1M will be worth $10.06 million at the end of the period (a pretty good result - which tells you that most investors probably don't even do this well). Assuming, for illustration purposes only, that our model enhanced approach enjoys a 3% average edge, i.e. an 11% per year return on average, the portfolio at the end of the 30 years would be worth $22.89 million (more than twice as much!). Compounding, properly harnessed, is a powerful ally of the long-term investor and enhanced indexing can be a powerful ally for long-term compounding.
