Enhanced Indexing
Encyclopedia
In finance, enhanced indexing is a catch-all term that describes strategies employed to outperform traditional indexing
. Enhanced indexing attempts to generate modest excess returns compared to index fund
s and other passive management
techniques.
and active management
.
Enhanced indexing resembles passive management
because enhanced index managers cannot (in principle) deviate significantly from commercially available indices which are derived from statistical bureaus like Standard & Poor's or The Frank Russell Company. Enhanced indexing strategies have low turnover and lower fees than actively managed portfolios.
However, enhanced indexing also to a certain extent resembles active management
because it allows managers the latitude to certain deviations from underlying index. These deviations can be used to minimize transaction costs and turnover, or to maximize tax-efficiency.
Index fund
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...
. Enhanced indexing attempts to generate modest excess returns compared to index fund
Index fund
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...
s and other passive management
Passive management
Passive management is a financial strategy in which an investor invests in accordance with a pre-determined strategy that doesn't entail any forecasting...
techniques.
Features
Enhanced indexing combines elements of passive managementPassive management
Passive management is a financial strategy in which an investor invests in accordance with a pre-determined strategy that doesn't entail any forecasting...
and active management
Active management
Active management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index...
.
Enhanced indexing resembles passive management
Passive management
Passive management is a financial strategy in which an investor invests in accordance with a pre-determined strategy that doesn't entail any forecasting...
because enhanced index managers cannot (in principle) deviate significantly from commercially available indices which are derived from statistical bureaus like Standard & Poor's or The Frank Russell Company. Enhanced indexing strategies have low turnover and lower fees than actively managed portfolios.
However, enhanced indexing also to a certain extent resembles active management
Active management
Active management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index...
because it allows managers the latitude to certain deviations from underlying index. These deviations can be used to minimize transaction costs and turnover, or to maximize tax-efficiency.
Strategies
Enhanced indexing comprises a wide range of strategies:- 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 their 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).
- 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.
- 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).
- 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).
- 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.
- 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.
Performance
The success of enhanced indexing is likely correlated to the degree of extra cost running an enhanced index fund. Tax-managed strategies are not expensive to implement, while the active management strategies would incur a higher cost structure.See also
- Relative returnRelative returnRelative return is a measure of the return of an investment portfolio relative to a theoretical passive reference portfolio or benchmark.In active portfolio management, the aim is to maximize the relative return...
- Dimensional Fund AdvisorsDimensional Fund AdvisorsDimensional Fund Advisors is an investment firm headquartered in Austin, Texas with regional offices in Amsterdam, Berlin, London, Santa Monica, Sydney, and Vancouver. The company was founded in 1981 by David G. Booth and Rex Sinquefield, both graduates of the University of Chicago Booth School of...
, an investment firm that uses enhanced indexing - Index Value, a website that discusses enhanced indexing