Enhanced Indexing is a portfolio management strategy that aims to beat the performance of a benchmark index by using active management techniques. Enhanced indexing is a hybrid approach that combines elements of passive and active investing.
In this article, we will explain what enhanced indexing is, how it works, and what are its advantages and disadvantages. We will also provide some examples of enhanced indexing strategies and funds.
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What Is Enhanced Indexing?
Enhanced indexing is a portfolio management strategy that tries to outperform a benchmark index by making small deviations from the index weights or composition. Enhanced indexing is based on the premise that some degree of active management can add value to a portfolio without increasing the risk or cost significantly.
Enhanced indexing can be applied to any type of index, such as equity, bond, commodity, or currency indexes. Enhanced indexing can also be used for different investment objectives, such as growth, income, value, or sustainability.
Enhanced indexing differs from strict indexing or passive investing, which involves replicating the index exactly and holding it for the long term. Passive investing does not attempt to beat the index but rather to match its returns and risk profile.
Enhanced indexing also differs from active investing, which involves making significant changes to the portfolio based on market analysis, research, forecasts, or opinions. Active investing aims to generate higher returns than the index by taking advantage of market inefficiencies or opportunities.
How Does Enhanced Indexing Work?
Enhanced indexing works by using various techniques to modify the weights or holdings of an index fund in order to generate modest excess returns compared to the index. Enhanced indexing techniques can be classified into four categories:
Index construction enhancements
These involve creating a customized or proprietary index that differs from the standard or commercial index in terms of selection criteria, weighting scheme, rebalancing frequency, or other factors. For example, an enhanced index fund may use a smart beta strategy that weights stocks based on factors such as volatility, momentum, quality, or value instead of market capitalization.
Exclusion rules
These involve applying additional filters or screens to eliminate securities that are likely to reduce performance or increase the risk that would otherwise be included in the index. For example, an enhanced index fund may exclude stocks with high debt levels, low profitability, poor environmental, social, and governance (ESG) ratings, or legal issues.
Trading enhancements
These involve using intelligent trading algorithms or strategies to create value through trading activities such as buying illiquid securities at a discount, selling overvalued securities at a premium, exploiting arbitrage opportunities, or minimizing transaction costs and market impact.
Portfolio construction enhancements
These involve implementing hold ranges, buffer zones, optimization techniques, or other methods to reduce portfolio turnover, tracking error, or tax implications. For example, an enhanced index fund may hold securities for longer periods even after they are removed from the index or use tax-loss harvesting to offset capital gains with losses.
What Are the Advantages and Disadvantages of Enhanced Indexing?
Enhanced indexing has some advantages and disadvantages compared to passive and active investing. Some of the advantages are:
- Higher returns: Enhanced indexing can potentially generate higher returns than passive investing by capturing some of the alpha (excess return) generated by active management techniques.
- Lower risk: Enhanced indexing can potentially reduce risk compared to active investing by maintaining a high correlation with the benchmark index and avoiding large deviations from the index weights or composition.
- Lower cost: Enhanced indexing can potentially lower costs compared to active investing by having lower fees, commissions, spreads, and taxes due to lower portfolio turnover and trading activity.
- Higher tax efficiency: Enhanced indexing can potentially increase tax efficiency compared to passive and active investing by using tax-managed strategies such as tax-loss harvesting, holding securities for longer periods to qualify for lower capital gains tax rates, or avoiding dividend-paying securities that generate taxable income.
- Lower cost: Enhanced indexing can potentially lower costs compared to active investing by having lower fees, commissions, spreads, and taxes due to lower portfolio turnover and trading activity.
- Higher tax efficiency: Enhanced indexing can potentially increase tax efficiency compared to passive and active investing by using tax-managed strategies such as tax-loss harvesting, holding securities for longer periods to qualify for lower capital gains tax rates, or avoiding dividend-paying securities that generate taxable income.
Some of the disadvantages are:
- Lower returns: Enhanced indexing can potentially generate lower returns than active investing by missing out on some of the alpha (excess return) generated by active management techniques.
- Higher risk: Enhanced indexing can potentially increase risk compared to passive investing by introducing some tracking error (deviation from the benchmark index) and manager risk (risk associated with the skill or judgment of the portfolio manager).
- Higher cost: Enhanced indexing can potentially increase cost compared to passive investing by having higher fees, commissions, spreads, and taxes due to higher portfolio turnover and trading activity than strict indexing.
- Lower tax efficiency: Enhanced indexing can potentially decrease tax efficiency compared to passive investing by generating more taxable events such as capital gains or dividends than strict indexing.
What Are Some Examples of Enhanced Indexing Strategies and Funds?
There are many examples of enhanced indexing strategies and funds in the market. Here are some of them:
Vanguard Tax-Managed Capital Appreciation Fund (VTCLX)
This fund seeks to track the performance of the Russell 1000 Index while minimizing federal income taxes on returns. The fund uses a proprietary index that excludes dividend-paying stocks and uses tax-loss harvesting to offset capital gains with losses. The fund has an expense ratio of 0.09% and a five-year annualized return of 17.34% as of June 30, 2021.
iShares ESG Aware MSCI USA ETF (ESGU)
This fund seeks to track the performance of the MSCI USA Extended ESG Focus Index, which is a customized index that selects and weights companies based on their positive environmental, social, and governance (ESG) characteristics while excluding negative ones. The fund has an expense ratio of 0.15% and a five-year annualized return of 18.04% as of June 30, 2021.
Invesco RAFI Strategic US ETF (IUS)
This fund seeks to track the performance of the FTSE RAFI US Index Series, which is a smart beta index that weights companies based on four fundamental factors: sales, cash flow, dividends, and book value. The fund has an expense ratio of 0.19% and a five-year annualized return of 16.35% as of June 30, 2021.
Schwab Fundamental U.S. Large Company Index Fund (SFLNX)
This fund seeks to track the performance of the Russell RAFI US Large Company Index, which is another smart beta index that weights companies based on four fundamental factors: sales, cash flow, dividends, and book value. The fund has an expense ratio of 0.25% and a five-year annualized return of 16.28% as of June 30, 2021.
In conclusion, Enhanced indexing is a portfolio management strategy that aims to beat the performance of a benchmark index by using active management techniques. Enhanced indexing is a hybrid approach that combines elements of passive and active investing.
Enhanced indexing can be applied to any type of index, such as equity, bond, commodity, or currency indexes. Enhanced indexing can also be used for different investment objectives, such as growth, income, value, or sustainability.
Frequently Asked Questions (F&Qs)
What are the two types of index funds?
There are two main types of index funds: mutual funds and exchange-traded funds (ETFs).
Mutual funds are baskets of stocks or bonds that are managed by a professional investment team. They can be bought and sold through a broker, and they typically have minimum investment requirements.
ETFs are also baskets of stocks or bonds, but they are traded on an exchange just like stocks. This means that they can be bought and sold throughout the day, and they typically have lower minimum investment requirements than mutual funds.
How do I start an index fund?
Here are the steps on how to start an index fund:
- Decide on your investment goals. What are you hoping to achieve with your index fund? Are you saving for retirement? Are you saving for a down payment on a house? Once you know your goals, you can start to choose the right index fund for you.
- Do your research. There are many different index funds available, so it’s important to do your research and choose the right one for you. Consider the fees, the investment objective, and the track record of the fund.
- Open an account with a brokerage firm. Once you’ve chosen an index fund, you’ll need to open an account with a brokerage firm. This will allow you to buy and sell shares of the fund.
- Make a deposit. Once you have an account, you’ll need to make a deposit. The minimum deposit amount will vary depending on the brokerage firm.
- Buy shares of the index fund. Once you’ve made a deposit, you can buy shares of the index fund. You can do this by placing an order through your brokerage firm’s website or mobile app.
- Monitor your investment. Once you’ve bought shares of the index fund, you’ll need to monitor your investment. This means checking the value of your shares regularly and making sure that the fund is still on track to meet your investment goals.