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Palmer [1995] estimates that approximately $100 billion is currently managed using enhanced index techniques. Of concern to investors is whether fund managers, in their pursuit of extra return (i.e., enhancement) invest in a way that pushes the fund unacceptably far from the index.
At least one disgruntled investor has stated that the term "enhanced index" is a misnomer: An enhanced index manager is an active manager. Results have been disappointing for [our] group of managers. Their performance objective is to exceed the return of the passive alternative by 100 basis points per year, net of fees. None of the four has reached that goal. In fact, we terminated one manager for significantly underperforming the benchmark. The other three have merely equaled or slightly underperformed the S&P 500 since they were hired (Halpern, Calkins, and Ruggels [1996, p. 70]). This article discusses the meaning of enhanced indexing and the different techniques used by enhanced index managers, and concludes with an empirical assessment of eight mutual funds that are classified in the enhanced index category.1 All the funds studied use the S&P 500 as their benchmark. We estimate which funds have provided enhancement and, of those, which can still plausibly be regarded as index funds. Of the eight funds tested, two have provided superior risk-adjusted returns while maintaining substantially the same characteristics as the S&P 500.
WHAT DOES
"ENHANCED INDEXING" MEAN? Defining enhanced indexing is difficult because so many purveyors of enhanced index products describe their mission differently. They all agree that they want to provide a return that is higher than the return on a specified index (although they disagree as to the expected size of the extra return). They diverge, however, as to what characteristics of the index they hope to match. In other words, the purveyors tend to have very different views as to what has to be done to stay true to the "index" part of the "enhanced index" label.
Besides low tracking error, some of the index characteristics that various purveyors seek to match include: Price-earnings ratio. Dividend yield. Beta.
Sector weights. Size weights. There is an admittedly subjective flavor to the debate as to which characteristics are most important and what is close or low enough. Later we provide evidence...