Investing in an enhanced index strategy may seem like an easy way of getting both active and passive exposure, but it may not be as straightforward as it first appears.
The advantages are clear. As Bryon Lake, head of Invesco PowerShares for the EMEA region, explains: “The pros are simple, in that it combines the best of passive and active. When delivered in the efficient exchange traded fund (ETF) wrapper, which tend to be lower cost, this is an ideal outcome for investors.
“However, investors must still do their due diligence before they buy and ensure that the enhanced index strategy lines up with what they are trying to achieve.”
Piera Elisa Grassi, portfolio manager at JP Morgan Asset Management, points out one of the benefits of enhanced index strategies is that they are designed to outperform its respective bench¬mark and to do so with risk characteristics similar to that benchmark.
She continues: “Like an index fund, [these] strategies are close to fully invested at all times, so do not engage in market timing. Sector weights are tightly controlled relative to the index’s sector weights and [they] continually monitor risk factor exposures relative to the index.
“This rigorous risk management results in portfolios that look like the index in terms of risk, yet are designed to offer potential excess return. Additionally, [these] strategies are focused on delivering consistent outperformance which minimises active risk, for example tracking error.”
One of the positives of this type of strategy is that it offers more tools to investors to express their views more accurately Shakista MukhamedovaUrs Raebsamen, senior equity strategist at UBS Asset Management, also points out that compared to pure passive strategies, enhanced index investing can achieve alpha at low levels of active risk.
“This alpha helps cover the cost of managing a portfolio and thus achieve higher returns than the index after transaction costs and the fee charged for management.
"However, active risk is a symmetrical risk measure and with the potential for outperformance comes the risk of underperforming the benchmark. In other words, the larger the active risk grows, the more difficult it becomes to further grow the alpha.”
Therefore due diligence and understanding exactly what these products are investing in is one of the most important issues when deciding on an enhanced index strategy.
Shakhista Mukhamedova, structured and passive investments analyst at Brewin Dolphin, acknowledges that one of the positives of this type of strategy is that it “offers more tools to investors to express their views more accurately, for example to allocate solely to value or growth stocks, or a portfolio of stocks with low volatility”.
