Enhanced Index Funds — What's in a Name?

By Randall Rohn
Analyst, mPower

In This Story Index Funds: A Review Enhanced Index Fund Strategies Stock Selection Synthetic Strategies Traditional vs. Enhanced Index Funds

During the 1990s, index funds went from pet to pariah in the eyes of many investors. In the early part of that decade, investors poured money into index funds based on studies showing they outperformed managed funds over time. Later, as the stock market soared, many pulled out of mutual funds altogether in favor of individual stocks.

Now that the stock market is coming back down to earth, investors may show renewed interest in index funds and particularly in enhanced index funds, which seek slightly higher returns by employing active management techniques.

minute: read this article at a glance.

Technical Terms Bond Derivative Sector Standard & Poor's 500 (S&P 500)

An index fund is a mutual fund that mimics a particular benchmark, like the S&P 500 Index. Traditional index funds replicate a benchmark by buying its component stocks in proportion to the index. Thus, the return earned by the fund should match that of the index. This is known as passive investing because it does not involve managers actively choosing which stocks to buy.

Enhanced index products put a different twist on the old theme of passive investing. They seek to combine the optimal features of both active and passive management to earn market-beating returns for shareholders.

If you're thinking of investing in an index fund that has "Enhanced," "Plus," or "Managed" in its name, you should first research it as you would an actively managed fund.

Index Funds: A Review

Index funds reached new levels of popularity in the early 1990s as proponents argued that these funds generally had lower expenses and superior tax efficiency compared to other mutual funds. Several studies also showed that index funds had outperformed most managed funds over time. Investors concluded that the relative certainty inherent in passive investing was worth more than the uncertainty that one could beat the benchmark in any given year.

As the stock market soared in the late 1990s, however, many investors opted to sell some of their stake in mutual funds and trade individual stocks in growth sectors, like technology, which were posting gains well beyond the broader market.

The year 2000 was something of a wake-up call for these investors. As the year's final trading session came to a close, all major domestic equity indexes posted losses for the 12-month period. And, the once red-hot NASDAQ Composite was the worst performing of the major market indexes. The technology-laden Index shed 39 percent on the year and suffered the greatest one-year statistical loss in its 29-year history.

Last year's stock market travails served as a useful reminder that markets don't always go up. Investors who sold their mutual funds to chase sexy high-tech stocks may be re-thinking their strategy.

Will they turn back to index funds? If they're still seeking a better-than-market return, they might try an enhanced index fund. But, will it really produce a better return?

Enhanced Index Fund Strategies

These funds can generally be recognized by their names. The typical enhanced product will carry the name of the index in conjunction with words like "Plus," "Managed," or "Enhanced." The Paine Webber Enhanced NASDAQ 100 Index Fund (PWNAX) and the Aetna Index Plus Large Cap Fund (AELAX) are two examples.

Enhanced index funds try to closely mirror a particular index, while earning returns that are a couple of percentage points over the benchmark. These funds employ two primary strategies to earn higher returns: active stock selection or the use of derivative securities.

Stock Selection

Stock selection is the simpler strategy of the two. Funds taking this approach typically begin with the designated index, commonly the S&P 500, as the starting point. The portfolio manager then draws on quantitative or fundamental analysis — the cornerstones of active management — to evaluate the individual index components and/or the economic industries that comprise the index.

From here, the manager may underweight the stocks or sectors she expects to underperform the index. This simply means the manager will place a percentage of assets in a particular stock or industry that is slightly lower than that of the benchmark. Conversely, the manager may overweight certain stocks or sectors vis-à-vis the index if she feels they represent superior investment opportunities.

In this way, enhanced index funds seek to modestly outperform the benchmark while maintaining a portfolio that exhibits similar valuation, market capitalization, and risk characteristics.

Synthetic Strategies

Many "enhanced" index funds have not delivered enhanced returns nor have they been altogether index-like.

Another class of enhanced index funds employs what is called a "synthetic" strategy. Synthetic products use a derivatives-based approach. A simple synthetic enhanced index strategy involves buying stock index futures and options, and owning them in tandem with the actual component stocks.

Futures and options are called derivatives because their value is derived from the value of the underlying asset. In the case of synthetic products, the underlying asset is the particular index the fund is designed to track.

While there are many types of derivatives, each essentially gives the investor either the right or the obligation to purchase or sell the underlying asset at some future date for a specified price. Managers purchase derivatives for enhanced index funds on the premise that when the index generates a positive return, the funds will benefit by having additional exposure to the index through the derivative investments.

Many enhanced offerings also seek to gain exposure to the index by using a small percentage of assets to purchase index futures. These funds then use the majority of assets to buy short-term investment-grade bonds. Managers of these funds try to capture the performance of the index through future contracts, while simultaneously enhancing that performance by actively managing a subportfolio of bonds. So, as an investor, you could buy an enhanced S&P 500 Index fund that is actually a portfolio of mostly bonds.

These are but a few examples of the strategies employed by enhanced index fund managers. But, it should be evident that, particularly in the synthetically enhanced category, many of these funds are decidedly different from the indexes they purport to track.

Traditional vs. Enhanced Index Funds

Many "enhanced" index funds have not delivered enhanced returns nor have they been altogether index-like. For example, a recent study released by Wiesenberger Thompson Financial tracked the performance of 40 enhanced index funds in comparison to their appropriate indexes.

Each fund was tracked from inception through Nov. 30, 2000. While roughly half of the enhanced funds bested their benchmarks, it is virtually impossible to detect a connection between outperformance and any single fund characteristic.

In addition to the added risks inherent in enhanced strategies, these strategies also invariably lead to greater turnover and higher expenses, both of which pure index funds seek to minimize.

Indeed, there does not even appear to be a correlation between performance and any particular enhanced strategy. For example, while 12 of the 24 funds tracking the S&P 500 bested that proxy over their lifetimes, the funds used a wide range of enhanced strategies.

More instructive, perhaps, is the performance of these funds over the nine months between March and November 2000, a period in which the market suffered a protracted downturn. Of the 30 enhanced funds tracking S&P or Russell stock benchmarks, 60 percent underperformed the index. Further, over half of the funds that outperformed the indexes over their lifetimes trailed them over the nine-month period.

The study suggests that enhanced index products exhibit characteristics common to actively managed portfolios. Some enhanced funds will invariably earn higher returns than the benchmark. But, as with all active management, there is no infallible method for determining in advance which funds will outperform.

Related Reading Deconstructing Index Funds Why Is the S&P 500 So Hard to Beat? What a Difference a Year Makes

In addition to the added risks inherent in enhanced strategies, these strategies also invariably lead to greater turnover and higher expenses, both of which pure index funds seek to minimize.

Given the circumstances, you should approach enhanced index funds as you would actively managed mutual funds. And, if you buy the argument that passive investing offers a superior alternative to the average actively managed fund, then enhanced indexing offers no compelling reason to abandon traditional index products. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Enhanced Index Funds — What's in a Name?

By Randall Rohn
Analyst, mPower

In This Story Index Funds: A Review Enhanced Index Fund Strategies Stock Selection Synthetic Strategies Traditional vs. Enhanced Index Funds

During the 1990s, index funds went from pet to pariah in the eyes of many investors. In the early part of that decade, investors poured money into index funds based on studies showing they outperformed managed funds over time. Later, as the stock market soared, many pulled out of mutual funds altogether in favor of individual stocks.

Now that the stock market is coming back down to earth, investors may show renewed interest in index funds and particularly in enhanced index funds, which seek slightly higher returns by employing active management techniques.

minute: read this article at a glance.

Technical Terms Bond Derivative Sector Standard & Poor's 500 (S&P 500)

An index fund is a mutual fund that mimics a particular benchmark, like the S&P 500 Index. Traditional index funds replicate a benchmark by buying its component stocks in proportion to the index. Thus, the return earned by the fund should match that of the index. This is known as passive investing because it does not involve managers actively choosing which stocks to buy.

Enhanced index products put a different twist on the old theme of passive investing. They seek to combine the optimal features of both active and passive management to earn market-beating returns for shareholders.

If you're thinking of investing in an index fund that has "Enhanced," "Plus," or "Managed" in its name, you should first research it as you would an actively managed fund.

Index Funds: A Review

Index funds reached new levels of popularity in the early 1990s as proponents argued that these funds generally had lower expenses and superior tax efficiency compared to other mutual funds. Several studies also showed that index funds had outperformed most managed funds over time. Investors concluded that the relative certainty inherent in passive investing was worth more than the uncertainty that one could beat the benchmark in any given year.

As the stock market soared in the late 1990s, however, many investors opted to sell some of their stake in mutual funds and trade individual stocks in growth sectors, like technology, which were posting gains well beyond the broader market.

The year 2000 was something of a wake-up call for these investors. As the year's final trading session came to a close, all major domestic equity indexes posted losses for the 12-month period. And, the once red-hot NASDAQ Composite was the worst performing of the major market indexes. The technology-laden Index shed 39 percent on the year and suffered the greatest one-year statistical loss in its 29-year history.

Last year's stock market travails served as a useful reminder that markets don't always go up. Investors who sold their mutual funds to chase sexy high-tech stocks may be re-thinking their strategy.

Will they turn back to index funds? If they're still seeking a better-than-market return, they might try an enhanced index fund. But, will it really produce a better return?

Enhanced Index Fund Strategies

These funds can generally be recognized by their names. The typical enhanced product will carry the name of the index in conjunction with words like "Plus," "Managed," or "Enhanced." The Paine Webber Enhanced NASDAQ 100 Index Fund (PWNAX) and the Aetna Index Plus Large Cap Fund (AELAX) are two examples.

Enhanced index funds try to closely mirror a particular index, while earning returns that are a couple of percentage points over the benchmark. These funds employ two primary strategies to earn higher returns: active stock selection or the use of derivative securities.

Stock Selection

Stock selection is the simpler strategy of the two. Funds taking this approach typically begin with the designated index, commonly the S&P 500, as the starting point. The portfolio manager then draws on quantitative or fundamental analysis — the cornerstones of active management — to evaluate the individual index components and/or the economic industries that comprise the index.

From here, the manager may underweight the stocks or sectors she expects to underperform the index. This simply means the manager will place a percentage of assets in a particular stock or industry that is slightly lower than that of the benchmark. Conversely, the manager may overweight certain stocks or sectors vis-à-vis the index if she feels they represent superior investment opportunities.

In this way, enhanced index funds seek to modestly outperform the benchmark while maintaining a portfolio that exhibits similar valuation, market capitalization, and risk characteristics.

Synthetic Strategies

Many "enhanced" index funds have not delivered enhanced returns nor have they been altogether index-like.

Another class of enhanced index funds employs what is called a "synthetic" strategy. Synthetic products use a derivatives-based approach. A simple synthetic enhanced index strategy involves buying stock index futures and options, and owning them in tandem with the actual component stocks.

Futures and options are called derivatives because their value is derived from the value of the underlying asset. In the case of synthetic products, the underlying asset is the particular index the fund is designed to track.

While there are many types of derivatives, each essentially gives the investor either the right or the obligation to purchase or sell the underlying asset at some future date for a specified price. Managers purchase derivatives for enhanced index funds on the premise that when the index generates a positive return, the funds will benefit by having additional exposure to the index through the derivative investments.

Many enhanced offerings also seek to gain exposure to the index by using a small percentage of assets to purchase index futures. These funds then use the majority of assets to buy short-term investment-grade bonds. Managers of these funds try to capture the performance of the index through future contracts, while simultaneously enhancing that performance by actively managing a subportfolio of bonds. So, as an investor, you could buy an enhanced S&P 500 Index fund that is actually a portfolio of mostly bonds.

These are but a few examples of the strategies employed by enhanced index fund managers. But, it should be evident that, particularly in the synthetically enhanced category, many of these funds are decidedly different from the indexes they purport to track.

Traditional vs. Enhanced Index Funds

Many "enhanced" index funds have not delivered enhanced returns nor have they been altogether index-like. For example, a recent study released by Wiesenberger Thompson Financial tracked the performance of 40 enhanced index funds in comparison to their appropriate indexes.

Each fund was tracked from inception through Nov. 30, 2000. While roughly half of the enhanced funds bested their benchmarks, it is virtually impossible to detect a connection between outperformance and any single fund characteristic.

In addition to the added risks inherent in enhanced strategies, these strategies also invariably lead to greater turnover and higher expenses, both of which pure index funds seek to minimize.

Indeed, there does not even appear to be a correlation between performance and any particular enhanced strategy. For example, while 12 of the 24 funds tracking the S&P 500 bested that proxy over their lifetimes, the funds used a wide range of enhanced strategies.

More instructive, perhaps, is the performance of these funds over the nine months between March and November 2000, a period in which the market suffered a protracted downturn. Of the 30 enhanced funds tracking S&P or Russell stock benchmarks, 60 percent underperformed the index. Further, over half of the funds that outperformed the indexes over their lifetimes trailed them over the nine-month period.

The study suggests that enhanced index products exhibit characteristics common to actively managed portfolios. Some enhanced funds will invariably earn higher returns than the benchmark. But, as with all active management, there is no infallible method for determining in advance which funds will outperform.

Related Reading Deconstructing Index Funds Why Is the S&P 500 So Hard to Beat? What a Difference a Year Makes

In addition to the added risks inherent in enhanced strategies, these strategies also invariably lead to greater turnover and higher expenses, both of which pure index funds seek to minimize.

Given the circumstances, you should approach enhanced index funds as you would actively managed mutual funds. And, if you buy the argument that passive investing offers a superior alternative to the average actively managed fund, then enhanced indexing offers no compelling reason to abandon traditional index products. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.