Best and worst of both worlds?

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For all the benefits enhanced indexing may offer – close index tracking with vital extra points of performance – the depth of its acceptance varies from country to country within Europe.
Frits Bosch, director of Netherlands consultancy Bureau Bosch, says enhanced indexing is very popular among pension funds in his country. For the last five years, an increasing amount of institutional money has been parked in the strategy, with funds drawn by the dual benefits of low-cost market exposure and extra returns.
“We used to have quite a bit in index mandates, but as the search for alpha goes on, more and more pension funds have switched over to enhanced indexing,” says Bosch. “That means the ratio of additional outperformance to additional risk is quite good.”
However, the forms of enhanced indexing offered do vary from one provider to the other, even though the differences are slight. “It’s an offshoot of indexing, and I would say there are about the same level of differences as there are in indexing.”
Gary Dowsett, senior investment consultant at Watson Wyatt in the UK, 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.
Bosch says enhanced indexing stays close to the benchmark, and should have a very low tracking error – around 0.5% would be normal. When a pension fund comes to select a provider for enhanced indexing, it is looking for a track record and for an asset manager who really can deliver alpha.
“Also, the second part is cost,” he says. “Costs are very important in this type of mandate.”
Enhanced strategies have proved immensely popular with pension funds over the last few years, but perhaps this surge of demand will level out. “I would say it’s about reached its top,” says Bosch. “Pension funds are really looking for added alpha, and the alpha you can find with enhanced indexing is limited. There won’t be a decline, but neither will there be very much more new_money from here.”
In Denmark, however, enhanced indexing is not a particularly popular strategy, says Hasse Nilsson, chairman of Alcifor Advisory Associates. The reasons for this mostly come down to Denmark’s ‘traffic light system’ – stringent regulatory requirements concerned with reserve status.
The regulatory structure effectively forces insurers and pension funds to seek more alpha, says Nilsson. “Enhanced indexing doesn’t have enough alpha,” he says. “Institutions would rather go for a more active approach.”
Simon Martin of Aon Consulting in the UK, says enhanced indexing is a neat term that captures a lot of different strategies. He is sceptical about how much enhanced indexing can actually offer pension funds in the long term.
“It’s another new idea that is generating interest,” he says. “All of these new ideas are great until the investment manager comes to see you three years later, and then they have all these wonderful excuses.”
Enhanced indexing derives from indexation, which is cheap, and where investment managers use no active judgement at all. Providers such as Legal & General and Barclays Global Investment are very good at running indexed funds, says Martin.
But then the motivation to develop enhanced indexing comes out of the dissatisfaction with the disadvantages of tracking. You are driven by whatever the index tells you to do, which means that if there is a stock with
a particularly negative outlook,
you are forced to follow its fate
“You can’t impose anything at all on it,” says Martin. But enhanced indexing does allow a manager to make certain judgements, and generate a tiny amount of outperformance but behaving tactically, for instance, in tweaking the timing of trades.
“For example, if you decide BP is a better bet than Shell, you can over-hold BP and under-hold Shell,” he says. Enhanced index managers are trying to get the best of both worlds, but they don’t tend to point out that you might get the worst of both, he says. “It is a little more expensive, and a little bit more risky.”
It is important that trustees at pension funds understand the way an enhanced index manager goes about generating the outperformance which gives the strategy its selling point, and if there are derivative structures in place.
“This goes back to what trustees should be thinking about,” says Martin. “If they are really scared of underperforming the index, then they should seriously think about indexing, or they won’t sleep at night.”

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