Enhanced indexing

Enhanced indexing is mixing of active and passive strategies within a single fund. Because it is presented as a variant on index tracking it is a more honest approach than that of closet trackers, and fees tend to be low. The active part of the strategy can be virtually any active strategy.

The presentation of enhanced index funds as essentially tracker funds with an opportunity to make a little in addition, is somewhat disingenuous. The level of out-performance that can reasonably be expected to correspond to the level of risk taken. There is not particular reason to expect that the managers of an enhanced tracker will deliver alpha any more reliably than the managers of an active fund.

What enhanced indexing does offer is a comparatively attractive package for investors who want an easily defined level of risk, as they usually target a defined tracking error. Investors should be aware that a defined tracking error only guarantees a low risk of index relative under performance. The risk to absolute losses is not explicitly controlled, although it is tied to losses on the index tracked.

Some strategies used for enhanced indexing, such as portable alpha, can add significant volatility without affecting beta, which means that beta is often not a valid measure of risk. However, limits of tracking error are still useful.

Like any strategy that mixes active and passive, enhanced indexing raises the question of what advantage it offers over holding a portfolio of passive and active investments. Unlike closet tracking supposedly active managers it does, at least, not lead to excessive fees. It could be replicated a combination of active and passive strategies. Other combinations could also allow control of absolute losses (e.g. most of the portfolio in gilts with a small proportion in high risk investments).

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