Dial 'R' to enhance
In recent years, a number of investment houses have started to offer what are known as ‘enhanced index’ products. These products have been available in the US and Australian markets for a number of years but are relatively new to Europe. We are set to hear more about them, so what do they involve?
‘Enhanced indexation’ describes products that seek to add value over a given benchmark, but to a lesser extent than traditional actively managed products. In general, enhanced index providers target a small level of outperformance by implementing a large number of small bets, while still closely tracking the characteristics of the benchmark. Quite where the borderline between enhanced index and traditional low-risk active management falls is debatable. It is impossible to agree a standard definition in terms of either expected outperformance or tracking error.
In markets such as the US, where enhanced index products have gained some popularity, the target outperformance for mainstream active products is higher than exists in the UK, allowing enhanced products to slot in neatly between passive and active strategies. In the UK, the existence of a number of active strategies which target a benchmark outperformance of +1% a year and a tracking error of roughly 150–250 basis points has blurred the distinction between low-risk active and enhanced index products. A number of products have emerged that straddle the line between these two categories because of the target tracking error, the outperformance objective or the techniques employed in the product.
The products that have come to the market as ‘enhanced index’ tend to be primarily from two models. There are those products that have been built from a passive platform: starting with an index fund, a large number of minor adjustments are made to the holdings to ‘enhance’ the return of the fund. On the other side are the active products, either run from quantitative or fundamental platforms, on which the risk ‘dial’ has been turned down. These active products generally aim to outperform the benchmark by less than 1% a year and hold a larger number of securities with smaller over and underweight positions than a corresponding higher-risk product.
There are opposing views as to whether this latter type should be categorised as ‘enhanced index’ at all, but rather ‘low-risk active’. In any case, there are a number of specific ways that the managers of these enhanced products add value to their portfolios. These can be split into four broad categories as follows:
q Flexible enhanced passive management. This area of enhanced indexing began with passive managers who moved away from regimentally tracking the index to closely tracking it but allowing for a slight tracking error to add value at the margin. For example, the manager could be permitted some leeway when index constituent changes occur, or be allowed to enter into stock lending agreements. For this type of product, the approach is to build an index-replicating portfolio, then to implement these enhancement techniques to add value. Some products go further by employing a large number of these techniques to gain a greater level of outperformance over the benchmark. Popular enhancement techniques are index changes, mergers and acquisitions trading, pairs trading, convertible bond investment and the exploitation of other short-term price anomalies.
q Cash management-based products. Some enhanced index products attempt to track an index by using futures or other derivatives to gain the relevant market exposure. An investor purchases a stock index future and has thus effectively ‘equitised’ its cash. The combined return on this portfolio (cash plus future) will be close to the performance of the index on which the future is based. It is therefore similar to holding a portfolio of the stocks in the underlying index. The investor then seeks to achieve a return on the cash which is in excess of that assumed in the pricing of the future. Most of the cash enhancement techniques tend to be very low risk, typically only seeking to add an excess return of 25–50bps.
q Low tracking error quantitative. These products use a quantitative research process to identify characteristics of stocks that are more likely, on average, to outperform the index. A typical characteristic to exploit would be the well-known phenomenon of the impact of earnings revision on stock prices, which has proved surprisingly robust. In their ‘enhanced index’ form, these products have strict risk controls that endeavour to ensure that bets are taken only at the security level.
q Low tracking error fundamental. This type of enhanced index product is similar to low tracking error quantitative investment, except that the positions taken are driven by the judgements of analysts carrying out fundamental stock research as opposed to being from quantitative research. Risk controls are applied more strictly than would be the case for a fundamental active portfolio with a higher outperformance target.
In reality, most enhanced index products are hybrids of the above four types. For example, an enhanced index product may seek to add value through quantitative research screens, but also adopt other techniques such as stock lending or stock/convertible bond substitution. Typically, enhanced managers employ a large number of very small bets in portfolios, even if the bet may only add a few basis points of outperformance. Most products hold a large number of stocks and are structured so that style, size, sector and other, non stock-specific bets remain neutral. The general goal of enhanced index strategies is to target the most efficient risk-return trade-off.
Within the European market, enhanced index products not only differ in their method, but also in their outperformance and tracking error targets. Some providers only aim to add about 30bps, while others are marketing products as ‘enhanced index’ which target +100bps, or greater. Tracking error targets differ considerably, and the target information ratios can range from 0.5 to 1.25.
The fee structures of these products also vary, although providers have realised that fees must be competitive given where the products fit on the scale between active and index-tracking products. A growing trend has been to structure the fee schedule so that a client pays passive fees for index performance, with a performance-related increment for those returns over and above the respective benchmarks.
Some would argue that many UK pension funds already use a mild form of enhanced indexation. Some providers of passive products do, very much at the margins, use techniques that are designed to achieve some limited outperformance of the market they are trying to track. This can be through, say, stock lending or management of index constituent changes. Leaving this aside, there are comparatively few UK pension funds using products that have been marketed as enhanced index vehicles.
If good products emerge, we expect to see them grow in popularity in the coming years, with the majority of their growth coming from clients that will move away from passive management. This has been the experience in the US. For this to happen, products will need to be realistically priced. It makes no sense to pay a typical active management fee for only limited outperformance expectations. The ideal is probably index tracking-type fees plus an element of any outperformance achieved. This fee structure does not necessarily lend itself well to those products labelled enhanced indexation that, in practice, are traditional active management products with the risk dial turned down.
In our view, the most attractive type of enhanced index product is one that seeks multiple sources of added value. To restrict yourself to certain techniques must ultimately be highly limiting. The successful enhanced indexer will thus be one who seeks to identify the maximum number of anomalies that can be successfully exploited.
Pension funds going down this route must also recognise that certain techniques may well have a limited shelf life. It is probable that the market will arbitrage away anomalies and the enhanced indexer must recognise this. Successful providers will be those who are able to update their processes and seek new techniques for adding value in portfolios. Enhanced indexation products, like all actively managed products, will need to evolve.
If the pricing is right and the number of well thought-through products continues to grow, then we expect pension funds to be attracted to this type of product. In five years’ time they may well be commonplace in pension fund manager structures.
Alexa Bodel and Andrew Barber are with Mercer Investment Consulting in London