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. Enhanced Index Fund - EIF

    An enhanced index fund is a fund that seeks to enhance the returns ...
  2. Indexing

    In the financial markets, indexing can be used as a statistical ...
  3. Index

    An index measures the performance of a basket of securities intended ...
  4. Total Return Index

    Total return indexes include any dividends in the calculation ...
  5. Closet Indexing

    Closet indexing is a strategy used to describe funds that claim ...
  6. Passive Management

    Passive management refers to index- and exchange-traded funds ...
Related Articles
  1. Investing

    Enhance Your Portfolio With Active Equity

    This strategy provides the potential for larger returns while using less capital.
  2. Investing

    5 Things You Need To Know About Index Funds

    Index funds, at their best, offer a low-cost way for investors to track popular stock and bond market indexes. But not all index funds are created equally.
  3. Investing

    3 Index Funds with the Lowest Expense Ratios

    Read detailed information about index mutual funds with some of the lowest expense ratios in their categories, and learn about their pros and cons.
  4. Investing

    Should Investors Nix Actively Managed Funds?

    Index fund returns are on a tear but does this mean investors should nix actively managed funds?
  5. Investing

    Fund Management Issues

    The quality of management is a key component of a fund's success.
  6. Insights

    This Bull Market Is Supported by the Index Funds Investment

    The massive growth of index funds has been supporting the bull market and could lead to a steeper correction when it happens.
  7. Retirement

    Should Mutual Funds Still Be in Your Retirement Plan?

    Mutual funds are still widely used in retirement plans, but they may be losing their appeal. Find out if retirement mutual funds should be in your portfolio.
  8. Investing

    High Mutual Fund Fees Can Be an Investment Drag

    Actively managed funds tend to charge more fees than index funds, but don't just assume your index funds are a bargain.
  1. How Do I Find Mutual Funds That Track Indexes?

    Two good sources for finding index funds are Fidelity Investments and Vanguard. Read Answer >>
  2. What are the disadvantages of an index fund over an actively managed fund?

    Read the advantages an actively managed fund has over its more staid compatriot, the indexed fund, and make your own decision ... Read Answer >>
Trading Center