Enhanced Indexing Can Enhance Your Portfolio

While the number of index funds has exploded in the last 15 years, most traditional index funds use the same basic approach they used more than 30 years ago.  Recent innovations now enable sophisticated investors and advisors to use enhanced index fund strategies that offer compelling advantages over traditional index funds.  Since traditional indexing is already superior to many other approaches, enhanced indexing is a powerful option.  Properly used it could meaningfully enhance your current portfolio.  Unfortunately, most investors have never heard of enhanced indexing.

ENHANCED INDEXING IS A STRUCTURED APPROACH TO INVESTING THAT BUILDS ON THE STRENGTHS OF TRADITIONAL INDEXING

Like traditional index funds, enhanced index funds offer the advantages of low operating costs, low turnover, and diversification.  The different approaches to enhanced indexing build on some of the key concepts of traditional indexing.  Recall that traditional index managers try to simply replicate or "track" the market averages (whether up or down).  Most traditional index managers simply attempt to replicate commercially available indexes that are supplied by the statistical bureaus like S&P.  In general, traditional index management is so focused on tracking that they are willing to incur greater transaction costs and suffer higher turnover in order to track the index as closely as they can manage.  As an example, if the S&P falls by 20%, the traditional index fund's object is also to be down by 20%.  Believe it or not, if the index fund fell only 19%, this would be considered a major failure (i.e. failure to track the index closely) and the index fund manager would likely be sacked.  This illustrates one weakness of traditional indexing, i.e. a greater focus on tracking than on risk adjusted returns.

As we discussed, active management, on the other hand, tries to beat the market index through security selection and sometimes market timing as well.  Many active portfolios have high turnover and higher fees than indexed approaches.  As we have already discussed in the indexing section, however, many active funds and managers don't keep up with the index over the long-term, especially net of fees.

Enhanced indexing is a structured approach that utilizes innovative techniques to manage diversified market-wide or sector-wide portfolios. It is different from both traditional index investing and traditional active management (though it is closer to indexing than to active management), because it combines elements of each.  Like traditional indexing, enhanced indexing emphasizes portfolio diversification and asset class exposures.  It also tries to minimize transaction costs and turnover while trying to maximize tax-efficiency.  Like active investing, however, enhanced indexing does emphasize returns and is willing to sacrifice tracking to get there.  In summary, enhanced indexing allows latitude to intelligently construct proprietary or dynamic indices (rather than replicate static commercially available index models).

DIFFERENCES BETWEEN TRADITIONAL AND ENHANCED APPROACHES TO INDEXING

Enhanced indexing comes in a variety of flavors.  Though specifics vary, some of the more common enhancement strategies (including those used by Dimensional Fund Advisors - or DFA) include:

1.      Index Construction Enhancements – Instead of relying on external indexes created by third parties like S&P or Dow Jones, enhanced indexes often use proprietary indexes.  Alternatively they use dynamic rather than static indexes.

2.      Exclusion Rules – By using additional filters, some enhanced indexes eliminate securities likely to reduce performance that would be otherwise included in traditional indices (e.g. companies with excessive debt or those in bankruptcy).

3.      Trading Enhancements – Utilizing intelligent trading algorithms, some enhanced index funds create value through trading (e.g. by buying illiquid positions at a discount or by selling more patiently than traditional index funds).

4.      Portfolio Construction Enhancements – Enhanced index funds sometimes implement hold ranges that reduce portfolio turnover by allowing funds to hold positions during buffer periods even after traditional sell signals are triggered.  

5.      Tax-Managed Strategies – Among the newest enhancements, tax-managed index funds manage buys and sells to minimize taxes.  These tax-managed index funds can be superior to variable annuities for tax-efficient wealth creation.

Now that you now know about enhanced indexing, you already have a head start.  How much difference can this knowledge make?  The better enhanced indexing strategies have outperformed their traditional index counterparts by 1% to 3% per year or more.  Since index funds can outperform some of the active funds by a similar margin over the long-term, enhanced indexing versus active investing can represent as difference of as much as 2% to 6% per year relative to the majority of active investing approaches. 

With compounding, a small annual different of as little as 2 to 3% really adds up - as illustrated by the following example.  Let's say you start with a $1M portfolio in a world with no taxes.  If the actively managed portfolio returns 8% over 30 years, the $1M will be worth $10.06 million at the end of the period (a pretty good result - which tells you that most investors probably don't even do this well).  Assuming, for illustration purposes only, that our model enhanced approach enjoys a 3% average edge, i.e. an 11% per year return on average, the portfolio at the end of the 30 years would be worth $22.89 million (more than twice as much!).  Compounding, properly harnessed, is a powerful ally of the long-term investor and enhanced indexing can be a powerful ally for long-term compounding.

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Copyright (c)  2006 The Ridgewood Group    Permission is granted to copy, distribute and/or modify this document under the terms of the GNU Free Documentation License, Version 1.2 or any later version published by the Free Software Foundation; with no Invariant Sections, no Front-Cover Texts, and no Back-Cover Texts.