By Richard Newell

Enhanced investment portfolios now enjoy a high profile, and indeed they look set for a bright future as products very much of their time. They are seen as an effective response to the excess volatility seen in active management in recent years. And in an environment of low inflation and interest rates in major economies, with the prospect of considerably lower returns from equities, they are also being used to boost returns from passive portfolios.

An enhanced index fund invests only in index stocks, but manages the portfolio actively. The manager will invest more in the stocks that he considers undervalued, less in the overvalued stocks and in the same weight in stocks that are fairly priced.

The enhanced equity strategy looks to typically deliver a target return 50 to 250 basis points above the benchmark. Key ingredients of an enhanced strategy are diversification, depth of fundamental and quant analysis, and low turnover. By spreading their positions over a wide range of stocks and by not focusing on any particular investment style, enhanced indexed managers aim to produce consistent outperformance.

This results in higher tracking error; to minimize this, the manager will stick closely (at least at the lower end of target expectations) to the benchmark sector weightings and style bias. So an enhanced index fund will look very similar to a traditional index fund. And it will achieve this through quantitative stock selection and stock substitution techniques.

The traditional quant index manager uses screening techniques to identify opportunities based on valuation, momentum or earnings surprise. Active managers offering enhanced management will use quantitative techniques and models to control risk across countries and sectors, and then build stock positions into the process.

Style tilt is the traditional way to manage for enhanced return. The main disadvantage of this approach is that it relies on the manager making bigger bets on style, which compromises the consistency of returns over time. Less concentrated portfolios result in less stock specific risk. This gives up on information ratio because less return is applicable to each position. However enhanced investors argue that for many investors, it is absolute return that matters, for any level of risk and therefore IR is not that important.

Arbitrage opportunities such as structural index changes, mergers and acquisitions and statistical arbitrage fall within the scope of enhanced management. The manager is only limited by the number of actual opportunities. Derivative trading strategies are also part of the enhanced index mix, although, at least with options, there is substantial downside risk involved. As one of the points it puts forward for pension investment managers to consider, Goldman Sachs suggests incorporating volatility-selling derivative strategies “like selling the extreme upside or downside equity/fixed income returns, to enhance returns in more moderate markets.”

So how do you increase alpha by 150 bps and maintain a low level of risk? This depends on which risk controls the manager relaxes. Most enhanced indexed managers have tight risk controls that limit the deviations from their benchmarks. This reduces the risk of performance substantially divergent from the index. But the question does highlight the fact that there are a number of different approaches to enhanced portfolio management, using different assets and levels of risk control.

Investors need to be sure what they want from an enhanced portfolio, and particularly to understand where the value is coming from. The real issue is how fund managers add value, by how much and what risks they are taking to achieve it. Typically, pension funds that will find enhanced to be suitable are those that are happy taking a little benchmark risk. Those that want a pure passive structure will stick with passive managers who might make use of minor enhancements.

For investors, the selection of an enhanced portfolio will depend on how this is intended to meld with other, more active, elements. Enhanced index management fills a low-risk gap between active managers and passive equity funds.

In Australia, the Perth-based industry fund Westscheme has made use of enhanced indexing as part of its on-going development. Chief executive Howard Rosario says the scheme’s investing has evolved from a desire to lower costs into a drive for good returns, based around the ‘two portfolio strategy’. This involves an on-going review of sources of alpha and management of the relationship between the market portfolio and the total return portfolio.

Some key lessons for Westscheme from the market downturn have been that members don’t like losses, they don’t like volatility and that relative out-performance has little merit. The scheme governors resolved to use strategies that would address these issues. Rosario says that in an increasingly competitive market, the risk associated with having an active manager significantly underperform is simply not worth taking. Funds are looking for the right variations on the passive idea because, if they underperform, the trustees can blame it on the index and not because the manager blew-up. This is easier to explain to members.

The fact that pension funds are taking this investment strategy seriously suggests it has a great future. In this context it is easy to see the attraction of enhanced indexing, in that the scheme gets a modest excess return while closely tracking the characteristics of a benchmark. Rosario adds that the advantages of using these managers include that they adopt a style neutral approach, rather than focusing on either growth or value styles.

The approach to enhanced manager selection highlighted by CalPERS in a recently circulated report is: to construct a portfolio of enhanced index managers with low correlation to one another: “This would enable CalPERS to maximize the information ratio of its global equity portfolio with a more persistent active return, lower risk, lower cost, and higher capacity approach, relative to the current set of managers employed by the fund.”
To this end, the report recommends that a ‘focused solicitation’ is appropriate, given the highly quantitative nature of these managers and the need to select managers whose strategies have a low correlation with one another. The CalPERS paper concludes: “We believe that the selection of and allocation to this category of low-risk but active managers can significantly improve the returns of our active manager line-up and eventually comprise a major portion of our active equity allocation.”

The concept of enhanced indexing is fairly new, especially in the context of non-US portfolios, so there is not such an authoritative outcome from analysis of relative returns from MSCI EAFE as from US index portfolios. However, from analysis carried out by SSGA, it is possible to say that enhanced strategies have outperformed both the US and non-US markets, irrespective of the market environment.

It is worth noting the comments from Goldman Sachs’ quant team: “No single approach can bring a quick resolution to the difficult market environment faced by holders of financial assets looking to meet future cash flow obligations. Pension managers and their agents, however, clearly need to look beyond the status quo and consider tools and approaches that were less applicable when equity returns were regularly in the neighbourhood of 20% and bond yields were above 5%.“This priority shift will require education for board members, improvements in risk management and more sophisticated performance analysis.”

Published in INVESTMENT & PENSIONS EUROPE, October 2003