Enhanced Indexing: Meaning, Types, Disadvantages

What Is Enhanced Indexing?

Enhanced indexing is a portfolio management approach that attempts to amplify the returns of an underlying portfolio or index and outperform strict indexing. Enhanced indexing also attempts to minimize tracking error. This type of investing is considered a hybrid between active and passive management; it combines elements of both approaches. Enhanced indexed is used to describe any strategy that is used in conjunction with index funds for the purpose of outperforming a specific benchmark.

How Enhanced Indexing Works

Enhanced indexing combines elements of both active management and passive management.

Enhanced indexing resembles passive management because enhanced index managers do not typically deviate significantly from commercially available indexes. Enhanced indexing strategies have low turnover, and therefore, they have lower fees than actively managed portfolios.

Enhanced indexing also resembles active management because it allows managers the latitude to make certain deviations from the underlying index. These deviations can be used to boost returns, minimize transaction costs and turnover, or maximize tax efficiency.

Types of Enhanced Indexing Strategies

There are many strategies associated with enhanced indexing.

Enhanced Cash

One such strategy is referred to as enhanced cash. With this strategy, managers use futures contracts to replicate the index. After buying the futures, they purchase fixed income securities. For this strategy to perform, the yield on the fixed income securities must be greater than the yield that is priced into the futures contracts.

Trading Enhancements

Some managers using this strategy may utilize intelligent trading algorithms in order to create value through trading—for example by buying illiquid positions at a discount or by selling more patiently than traditional index funds.

Index Construction Enhancements

Enhanced indexing strategies often make use of proprietary indexes in place of those indexes created by different third parties, such as Dow Jones or S&P. These exclusive indexes are typically dynamic rather than static indexes.

Exclusion Rules

With enhanced indexing, it's possible to create additional filters that effectively eliminate certain undesirable companies, such as those with excessive debt or those in bankruptcy. If an investor was relying on a traditional index, these companies may still be included.

Tax-Managed Strategies

Tax-managed index funds buy and sell based on what will reduce taxes the most for investors. This strategy makes sense if the portfolio exists outside of a tax-advantaged account, such as a 401(k) or a 529 plan.

Other Strategies

Investors can short-sell poor performing stocks from an index and then use the funds to purchase shares of companies they expect will have high returns, in effect tilting the index fund’s weights. Investors could outperform a benchmark over long time horizons by consistently eliminating their exposure to poor performing stocks and by using the proceeds to invest in other securities.

Enhanced index funds can be more profitable than regular index funds by positioning the portfolio to a particular sector, timing the market, and investing only in specific securities in the index. They may also avoid certain securities in the index that are expected to underperform, use leverage, and keep up to date with market trends.

While an enhanced index fund will create additional costs for the investor, the success of enhanced indexing is directly correlated to the extra expense. Of these strategies, any active management strategies will incur higher costs, while tax-managed strategies are not expensive to implement.

Disadvantages of Enhanced Index Funds

Since enhanced index funds are essentially actively managed, the investment has additional risk in the form of manager risk—whereas index funds only have to worry about market risk. Poor choices by the manager can hurt future returns. Also, because enhanced index funds are actively managed, they have higher management expense ratios compared with index mutual funds.

Enhanced index funds typically have expense ratios between 0.5% and 1%, compared with 1.3% to 1.5% for regular mutual funds. Because enhanced index funds are actively managed, they typically involve higher turnover rates, which means more brokerage transaction fees and capital gains. They are also newer investment instruments and do not have that long of a track record to compare performance.