John Spence

Enhanced Indexing

There wasn't a lot of emphasis placed on enhanced indexing during the bull market of the 1990s when investors were fed a steady diet of consecutive and unprecedented high yearly returns. However, with the recent stock sell-off, squeezing out those extra percentage points can make a difference, and is causing many investors to explore the risks and benefits associated with enhanced indexing.

How Does Enhanced Indexing Work?

Managers who use an enhanced indexing strategy seek to outperform an index through a limited amount of active management. There are two approaches to enhanced indexing: the stock-selection strategy and the derivatives-based, or synthetic, strategy.

Stock-selection is the more simplistic of the two strategies that employs a regulated amount of active management and stock-picking by a fund manager. To be considered an "enhanced indexing" strategy, it is commonly held that tracking error should not exceed 2.00%. But generally, the fund manager will utilize quantitative analysis and research to identify stocks or sectors that may outperform, and overweight in those stocks or sectors. As is true with all active management, a major hurdle is overcoming transaction costs.

The second approach that is becoming more widespread - the synthetic strategy - uses derivative contracts in an attempt to outperform the returns of the index. A common form of synthetic enhanced indexing involves owning futures, which is in a sense a "buy now, pay later" approach. For example, margin rates for S&P 500 futures currently run about 5% of the total contract value. The remaining 95% of the investment can then be placed in short-term fixed income investments. The trick is to outperform the London InternBank Offered Rate (LIBOR) with the fixed income investments. LIBOR is the financing rate associated with S&P 500 futures, so returns above LIBOR lead to enhanced performance.This is just one example of the many complicated strategies used in synthetic enhanced indexing. Also, many managers combine the stock-picking and synthetic strategies in a hybrid approach.

The standard by which enhanced indexers measure themselves is Information Ratio, which is determined by dividing the excess return percentage by the tracking error percentage. An enhanced index fund manager with a relatively high Information Ratio is considered successful.

Does Enhanced Indexing Work?

Wiesenberger, a division of Thompson Financial, today released a study that examined the performance of 40 enhanced index funds, 24 of which were based on the S&P 500. Wiesenberger compared the enhanced index fund returns against their respective indexes for the life of each fund. To see how the enhanced index funds reacted to the recent market downturn, they performed the same analysis over the period between March and November 2000. All performance data was calculated as of 11/30/2000.

Performance Over Fund Lifetime

Source: Wiesenberger study - Enhanced Index Funds or In Need of Enhancement

Fund Performance, March-November 2000

*The PaineWebber Enhanced S&P 500 Index Fund and the Nasdaq 100 Index Fund didn't exist during the period between March and November 2000[/:Author:] Source: Wiesenberger study - Enhanced Index Funds or In Need of Enhancement

The most striking thing about the results of the study is the lack of any conclusive proof that one type of enhanced index fund outperforms its peers. The size, name, enhanced strategy, or experience of a fund family did not have a big impact on the results of the study. For example, the 12 funds that outperformed the S&P 500 over their lifetimes employed diverse approaches to enhanced indexing. There doesn't appear to be a correlation between one type of strategy and an increased likelihood that it will beat its index.

Additionally, Wiesenberger found no correlation between a fund's degree of success and the type of index tracked, or the index's own performance. It is also interesting to note that over half of the funds that beat the index over their lifetime lagged the index between March and November 2000.

The age of a fund does not appear to affect the likelihood that it will outperform its index. The 19 funds that outperformed the index over their lifetime had an average age of 5.45 years, while the 21 funds that lagged the index had an average age of 5.55 years.

Generally, the findings of the study seem to support the idea that enhanced indexing shares many characteristics with active management. Although some managers will beat the index, it's difficult to identify in advance who those managers might be because there is no conclusive proof that one type of enhanced index fund will outperform the next.