Index funds have been one of Wall Street’s more ingenious innovations. They are transparent, cheap to buy and own, and provide solid relative performance.

Proponents such as John Bogle of Vanguard and Princeton economics professor Burton Malkiel boast that the low-cost pure market exposure that indices offer is hard to beat. Studies of active fund performance bear this out.

Management firms have been tweaking indices to boost performance further. Enhanced indexing starts with a brand name index, such as the S&P 500, and then, for example, adjusts the constituent weighting from market cap to equal weighting.

Some strategies leverage exposure by buying index futures then investing the bulk of assets into bonds whose returns could provide a net edge over the market. Other products short the index to profit from a broad market decline. Then there are active strategies that increase exposure to stocks that are likely to rise and reduce exposure to those that may underperform.

According to Reuters, 38 “enhanced” equity index mutual funds were trading in the US before 2000. That jumped to 78 by the end of 2000 with a total asset value of $5.89bn. By the end of 2006 the number more than doubled to 196, worth $10.2bn. And in the first four months of 2007, 19 newcomers helped boost the net value of enhanced funds to $11.3bn.

This figure is tiny compared with the straight index mutual fund world. As of the end of April, assets in 1,220 public index funds totalled $1,250bn. This gap may explain why index enhancers think they can tweak out superior gains.

But according to Peter Jankovskis, chief investment officer of Oakbrook Investments, the lion’s share of enhanced indexing money is in proprietary accounts. His firm, based in suburban Chicago, has more than 70 per cent of its $1.4bn in assets under management in such accounts.

Jankovskis’ strategy is based on a quantitative model that focuses on behavioural factors such as near-term short-selling, price volatility and trading volumes. He compares indices’ constituents to create a uniquely weighted portfolio. If his metrics generate a particularly negative read on a security, he deletes it.

Up to the end of March, Oakbrook’s S&P 500-related product has topped the index by about 1 percentage point over the past year and by an average 75 basis points over the past five years, net of expenses.

But enhanced indexing is not automatically a better way to invest. Making portfolio adjustments pushes up fund expenses by as much as seven times the cheapest index funds. So these strategies must generate alpha that more than covers this additional cost.

Morningstar, the Chicago-based mutual fund tracking group, ran a comparative analysis of all enhanced funds. Of the 58 benchmarked to the S&P 500, the average return across various time periods underperformed the S&P 500. Up to the end of May, one-year average returns trailed the index by 314bps. The gap diminished over time to 56bps for the past 10-year period, which captured a significantly smaller universe of enhanced funds.

Morningstar found comparable results for funds geared to the Russell 1000 (large cap) Index and the S&P Small-Cap 600. Enhanced mid-cap focused index funds outperformed their benchmarks over the past year but trailed over three and five years.

Oakbrook’s study of enhanced index performance of institutional managed accounts contrasts with this. Between 2001 and 2006, it found, 88.9 per cent of enhanced large-cap index programmes topped the S&P 500. Over the past 10 years, the proportion slipped only slightly to 87.5 per cent. In both periods enhancement substantially outperformed active management, especially when the strategies tracked the index closely.

Enhancement raises a further issue: at what point does altering an index constitute active management? Actively managed funds that traditionally perform close to their benchmarks are often accused of being expensive closet index funds. It is possible that enhanced funds that substantially alter the composition of an index should be considered actively managed.

Russell Kamp, chief executive of Invesco Structured Products Group, believes that by choosing an enhanced strategy over a traditional one for large-cap domestic equity allocation, “greater certainty of performance relative to the benchmark may be achieved while lowering the overall risk exposure”. Kamp oversees $5.7bn in 10 enhanced equity fund assets.

Given the relatively small proportion of assets in enhanced versus traditional indexed funds, Kamp thinks there remains sufficient capacity in the domestic large-cap segment to accommodate significant growth.

But Kunal Kapoor, Morningstar’s director of fund analysis, cautions investors. “You can be as enhanced as you want to be,” he says, “but if you have a truckload of expenses, the enhancement isn’t going to amount to much.”

With a the number of enhanced choices growing, investors should find affordable options.

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