The value-added in enhanced

Enhanced indexing has seen a huge increase in use over the last few years, with institutions looking to tap into higher returns while still holding on to the low-cost levels of traditional passive investment. But what is meant by the term, exactly?
Enhanced indexing, says Gary Dowsett, senior investment consultant at Watson Wyatt in the UK, is a low-cost, low-risk variation of index tracking meant to add alpha to a chosen benchmark. “The way we approach it, it achieves added value for the lowest additional risk,” he says. Watson Wyatt’s approach is to start with an index and add strategies.
But the approach taken by the many asset managers offering enhanced indexing products differs. “The biggest problem with it in terms of nomenclature is it isn’t very well defined,” says Stephen Woodcock, senior investment consultant at Mercer in the UK.
Mercer regards enhanced indexing as low-risk active management, but there are quite a number of techniques that could achieve that,
he says. Probably most of them
are quantitatively based, he says, rather than active. “They’re more model-based because for enhanced indexing to work, it has to charge lower fees to be economically viable,” he says. However, there are also some low-risk active funds which fall into the category.
Perhaps the definition of enhanced indexing depends where you live. Some say the concept of enhanced indexing is perceived differently on the two sides of the Atlantic. “In Europe, enhanced indexing is a specialist strategy,” says Roland van den Brink, chief investment officer of the PME pension fund, “It’s just a smart way to do business better. But in the US, enhanced indexing is seen as active.”
Merrill Lynch Investment Management in the Netherlands sees two basic approaches. The first takes the index as the basis, making a number of small bets by overweighting and underweighting – usually keeping tracking error against the index of between 100 and 150 basis points.
“The other way is scaled-down active management,” says Martijn Hoogendijk, director of institutional sales at MLIM in the Netherlands. The manager scales down the size of holdings in the portfolio in order
to arrive at a lower tracking error, which can be up to around 300 basis points. “One can argue whether this
is still enhanced indexing,” he says.
Mercer, at least, considers that
there is a tracking error limit on enhanced index funds of 1.5% or 2%, says Woodcock.
Dowsett identifies four different basic approaches to enhanced indexing that are out there in the investment sphere. In the first type, the manager has an in-house team working with recommendations from analysts and constructs a portfolio. This is rare, however, he says. There is also the derivative approach, where the manager holds cash and uses derivatives to gain exposure. The third and most common approach is a combination of quantitative analysis – making a model that focuses on identifying companies with strong price momentum and attractive valuation.
There is also a ‘technical’ approach which revolves around taking advantage of index changes, arbitrage possibilities, pricing inefficiencies and stock substitution in cases where there is a double listing. “We feel that is a relatively low-risk strategy, combined with a quantitative approach,” says Dowsett.
How much value can enhanced indexing really add? It all depends on the level of risk that the manager decides to take. “Enhanced indexing has a very attractive risk/return profile,” says Hoogendijk. “It usually targets returns roughly equal to the tracking error.” So returns are likely to be between 50 and 150 basis points above the index, with a tracking error to match that, he says.
“Which gives you an information ratio of one, which is extremely high,” he says. So moving out of index funds into enhanced is a good way of adding value, especially in this environment. Fees, too are very competitive, he says. “They are not as low as index management, but not much higher.”
Dowsett says investment managers offering enhanced indexation tend to be those expert in managing passive strategies. However, there are two or three active managers who have had the resources to build up strong quantitative databases, he adds.
Many of the enhanced index providers emanate from the US, where managers have been using quantitative investment for longer. “Those managers are now broadening their capability to enhanced indexation in Europe as well,” he says.
In the future, Watson Wyatt sees more pension funds – the ones that have the governance to put this in place, at least – including enhanced indexation as a layer of investment between their passive and satellite funds.
The momentum behind the popularity of enhanced indexing comes from two directions, says Dowsett. First, in the US, active managers were not delivering good returns and, secondly, quantitative managers demonstrated that they could do so, and at low risk too.
Hoogendijk says many of the larger pension funds in the Netherlands that have large passive portfolios are moving some of this business to enhanced. But he also sees some investors moving to enhanced indexing and away from active management. “These are investors who want to bring down the active risk in their portfolios,” he says.
As well as its pooled offerings, MLIM undertakes enhanced indexing in segregated mandates. For these, it can take any large index. The investment team is based in New York, and the funds are packaged for tax efficiency. “We offer US limited partnership structures to clients in Europe, because they can be more tax efficient to investors that are tax-exempt,” he says. In the Netherlands, pension funds that are incorporated as foundations can reclaim tax.
Dowsett doubts that some of managers operating in the field can really be classified as passive managers at all. “We would say those managers that have a high tracking error, of two or three percent – the active quant managers – they are still active. This is why we prefer the lower tracking errors. That is where you can generate the higher information ratios,” he says.
Apart from the favourable information ratios, the fee structures are more attractive for this type of management. Base fees can be just 10-12 basis points with 15-20% of outperformance, he says.
Just how much a fund will pay for enhanced indexing depends on the size of the assets involved. For PME’s E1bn enhanced indexing fund with State Street, for example, fees are just 10 basis points, says van den Brink.
Clients of Watson Wyatt that have taken up enhanced indexing have tended to be the larger schemes, says Dowsett. “The smaller schemes tend either to be passive or active. That makes sense at the moment. But that could change if enhanced indexation becomes more popular.”
Some question the role of enhanced indexing in an environment where, increasingly, institutional investors are turning to absolute returns. In a recent study by JPMorgan Fleming Asset Management into the search for higher performance among Europe’s institutional investors, researchers have detected a move away from the constraints of indices.
The findings suggest “a general desire among European institutional investors to move away from constrained active management
and instead use a more extreme
‘barbell’ structure of fully passive index-tracking in some markets and fully unconstrained active strategies in others.”
Perhaps enhanced indexing is part of this change in behaviour. Woodcock says that it is sometimes felt that enhanced indexing is a natural step back into active management for players that lost faith with it in the 1990s.
There is evidence that institutions are creating enhanced indexing as a new layer. When CalPERS, the California public employee pension fund, selected ten investment managers this summer to form part of a pool to invest up to $6bn (e4.8bn) in US equity enhance index strategies, it said it would take equally from its index and active equity managers to fund the pool.
“I think we’ll see more assets going into enhanced indexing,” says Woodcock, but just how much is impossible to say.
Van den Brink says there is a trend within enhanced indexing now for managers to use the tools that allow them to operate in some of the ways that hedge funds do. A lot of investors are looking at the hedge fund industry at the moment, and now enhanced index specialists are offering to add value by using long, short and options strategies too.

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