Enhanced Indexing
By John Spence,
Associate Editor
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
|
Index
tracked
|
Sector
|
No.
of funds
|
No.
of funds outperformed
|
No.
of funds underperformed
|
%
success |
|
S&P
500
|
Large
Cap
|
24
|
12
|
12
|
50.00%
|
|
S&P
400
|
Mid
Cap
|
3
|
2
|
1
|
66.66%
|
|
S&P
600
|
Small
Cap
|
2
|
1
|
1
|
50%
|
|
Russell
1000 Growth
|
Small
Cap Growth
|
1
|
0
|
1
|
0.00%
|
|
Russell
100 Value
|
Small
Cap Value
|
1
|
0
|
1
|
0.00%
|
|
Nasdaq
100
|
Technology
|
1
|
1
|
0
|
100.00%
|
|
Lehman
Bros. Aggregate Bond
|
General
Bond
|
1
|
0
|
1
|
0.00%
|
|
Lehman
Bros. Gov/Corp
|
Gov/Corp
Bond
|
1
|
0
|
1
|
0.00%
|
|
Blend
- 60% S&P 500, 40% Lehman Bros. Agg. Bond
|
Hybrid
|
2
|
0
|
2
|
0.00%
|
Source:
Wiesenberger study -
Enhanced Index Funds or In Need of
Enhancement
Fund Performance,
March-November 2000
|
Index
tracked
|
Sector
|
No.
of funds
|
No.
of funds outperformed
|
No.
of funds underperformed
|
%
success |
|
S&P
500
|
Large
Cap
|
23*
|
10
|
13
|
41.66%
|
|
S&P
400
|
Mid
Cap
|
3
|
0
|
3
|
0.00%
|
|
S&P
600
|
Small
Cap
|
2
|
0
|
2
|
0.00%
|
|
Russell
1000 Growth
|
Small
Cap Growth
|
1
|
1
|
0
|
100.00%
|
|
Russell
100 Value
|
Small
Cap Value
|
1
|
1
|
0
|
100.00%
|
|
Nasdaq
100
|
Technology
|
1*
|
n/a
|
n/a
|
n/a
|
|
Lehman
Bros. Aggregate Bond
|
General
Bond
|
1
|
0
|
1
|
0.00%
|
|
Lehman
Bros. Gov/Corp
|
Gov/Corp
Bond
|
1
|
0
|
1
|
0.00%
|
|
Blend
- 60% S&P 500, 40% Lehman Bros. Agg. Bond
|
Hybrid
|
2
|
1
|
1
|
50.00%
|
*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
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.
12/21/2000
