THE SOUTH AFRICAN INDEX INVESTOR
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APPLYING INDEX STRATEGIES
3. Enhanced Indexing # Download full version...
Enhanced indexing has two basic goals in relation to both active management and passive management: to outperform the index while maintaining the risk characteristics of the index. The first objective, to outperform the index, requires a robust and stable alpha that is consistent over different investment cycles and sustainable over time. The second objective, risk containment, naturally constrains the first objective to a modest level of excess returns, especially when compared to traditional active strategies.
The industry’s generally accepted definition of an enhanced index fund is that it is a strategy that seeks to outperform an index benchmark by less than around 1.5% with tracking error of less than 3%, usually lower. As such, enhanced indexing is often considered a superior form of investing because it leads to more consistent performance with minimal turnover and low transaction costs. The combination of active and index management draws upon the best of both investment strategies. Enhanced indexing requires the skills needed to identify and maintain alphas, combined with the expertise required to understand the index. The resulting benefit of the nexus between active and index techniques in successful enhanced index strategies is the potential for high information ratios.
The information ratio summarizes the risk and return properties of an active portfolio to access performance relative to a benchmark. It can distinguish between the skilled portfolio manager, who achieves outperformance with relatively little risk, from the “cowboy” portfolio manager who achieves outperformance through very high risk strategies. It can also differentiate between strategies that have the opportunity to achieve greater outperformance relative to a benchmark by examining the number of bets it takes away from the benchmark.
We define passive management as a portfolio technique constructed to match the assets and activity of an index with the objective of replicating the index return. We define active management as a portfolio technique that takes explicit bets away from the index (and therefore adding risk) with the objective of outperforming the index/generating alpha. Enhanced indexing (EI) lies relatively close to passive strategies and falls within the linear spectrum between passive and active strategies.
More appropriate would be a definition based on the actual investment techniques employed by the manager, not the expected results (which investors should know may not be an indicator of future performance). Sources of properly defined enhanced indexing strategies fall under two broad categories: securities-based strategies and derivatives-based strategies. Each method attempts to exploit a different form of capital market imperfection and inefficiency. They also seek to take advantage of index methodology idiosyncrasies and/or capital market inefficiencies.
Securities-based enhanced indexing strategies
Securities based strategies rely on a diversified portfolio of stocks to replicate the risk characteristics of the index, and they exploit alpha through relative-value mispricings or event-driven opportunities. In a relative-value situation, the alpha source comes from temporary price deviations between two securities with an established relationship or historic correlation.
Constructing a securities-based portfolio involves identifying the appropriate alpha sources and choosing a technique to control tracking error relative to the benchmark. The majority of the portfolio is constructed for the purpose of replicating the index. A portion of the portfolio is then devoted to achieving alpha by overweighting or underweighting the sources of alpha.
Derivatives-based enhanced index strategies
A derivatives-based approach to enhanced indexation seeks to replicate index performance through synthetic vehicles derived from the underlying index, such as futures, options, swaps and other exchange-traded vehicles. Derivative-based approaches can simplify the complexities involved in maintaining securities-based strategies. However, just as in stock-based approaches, they also increase risk and tracking error relative to the benchmark.
The beauty of enhanced indexing is that techniques can and will evolve as new market inefficiencies develop, whether in the underlying equity market, in the listed and OTC derivatives markets, with the growth of ETFs and ETF derivatives, or even in the fixed-income market. And these capital market opportunities will be uncovered by a variety of players in this space—index fund managers who see opportunity that lies just beyond the mandate of their index-tracking funds, active managers who increasingly will be expected to adhere to rigorous risk parameters, hedge funds that will continue to target index changes and dividend season, and the dealers who service all of these actors.
Ultimately, diversification is as vital to an investor’s overall policy mix and selection of managers as it is within portfolios. Enhanced index strategies provide a source of index alpha that is not targeted or produced by traditional active managers or by most risk-controlled active strategies.
Through this risk budgeting approach, an enhanced index strategy can be combined with a blend of a core index approach (to reduce active risk) or risk-controlled active and traditional active management to add value and increase returns.
# Excerpts from an article: “Enhanced or Active? Precisely Defining Enhanced Indexing and Risk-Controlled Active Management” by Steven Schoenfeld and Joy Yang. Journal of Indexes, Fourth Quarter 2003. Available at http://www.indexuniverse.com/JOI/index.php?id=206