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What is enhanced index investing?

This article is part of
Guide to enhanced indexing

What is enhanced index investing?

Passive investing has gained in popularity in recent years, partly due to more market volatility and uncertain economic conditions, so it is not surprising the industry has evolved with it. 

Enhanced indexing, sometimes called smart beta or alternatively weighted index investing, is predominantly a passive index tracking strategy, either through a tracker fund or an exchange traded fund (ETFs) with an added element of active management. 

This active portion is generally in the form of altering the weightings to stocks in an index, for example instead of being market cap weighted, it could be allocated according to dividend yield, volatility or fundamental aspects such as earnings. 

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Martin Weithofer, head of strategic beta at Deutsche Asset Management, explains: “When passive investing first started to become popular the focus was purely on tracking capitalisation-weighted indices. 

“But as the market has matured that focus has spread to look at other ways to track indices, and ways that may be more optimal, such as equal-weighted, dividend-weighted, and quality-weighted. There’s certainly demand for these types of tilts and the risk and reward profiles that they produce.”

This demand is supported by the fact there are more than 200 ETFs in Europe that “screen stocks according to dividend or exposure to a certain risk factor such as quality, value, growth, low volatility and so on,” notes Shakhista Mukhamedova, structured and passive investments analyst at Brewin Dolphin. 

Enhanced indexing can therefore be considered a middle ground between a purely active and a purely passive approach. 

Urs Raebsamen, senior equity strategist at UBS Asset Management, says: “As opposed to passive strategies, enhanced index strategies aim to outperform their benchmark, however, at significantly lower levels of active risk than typical active strategies.

“The goal of enhanced indexing is to generate modest alpha in a cost- and risk-efficient manner.  Enhanced indexing portfolios can be constructed applying a number of different approaches such as but not limited to exclusion rules, tax managed strategies, index construction enhancements, trading enhancements or by using multifactor stock selection models.”

But while it may have become more popular recently, enhanced index investing is not a new concept, with Nizam Hamid, head of ETF strategy at WisdomTree in Europe, suggesting it has been a feature of investment styles “for more than a decade”. 

He adds: “There are currently two important strands of enhanced index investment, one into alternatively weighted strategy indices; these aim to provide investment solutions to specific challenges be it the search for income, diversification of investment styles and tapping into unique themes and investment strategies. 

“The other school of enhanced indexation is focused more closely on identifying and building specific factor-based solutions. The aim here can be to offer dedicated exposures that may counter structural portfolio issues.”

Overall, however, Martin Bamford, managing director of Informed Choice, suggests this type of investment philosophy “is an attempt to improve the returns from an underlying index fund. It is a bit of a hybrid approach between true index investing and active fund management.