DEFINITION of 'Enhanced Indexing'

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

BREAKING DOWN 'Enhanced Indexing'

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

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

Finance experts are split on whether enhanced indexing is truly active or passive.

How Enhanced Indexing Works

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
  • Investing only in specific securities in the index
  • Avoiding certain securities in the index that are expected to underperform
  • Using leverage
  • Keeping up to date with market trends

Drawbacks of Enhanced Index Funds

Since enhanced index funds are essentially actively managed, the investment has additional risk in the form of management 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.

Enhanced Indexing Strategies

  • Enhanced Cash
  • Index construction enhancements
  • Exclusion rules
  • Trading enhancements
  • Portfolio construction enhancements
  • Tax-managed strategies
  • Smart beta
  • Factor investing
  1. Index Investing

    Index investing is a passive strategy that attempts to track ...
  2. Active Index Fund

    Active index funds track an index fund with an additional layer ...
  3. Composite

    A composite is a grouping of equities, indexes or other factors ...
  4. Total Return Index

    Total return indexes include any dividends in the calculation ...
  5. Passive Investing

    Passive investing is an investment strategy to maximize returns ...
  6. Benchmark

    A benchmark is a standard against which the performance of a ...
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