A Look At Enhanced Index Funds
Sound conventional wisdom says index funds should be the core of your investment portfolio. There are some great reasons including lower fees, lower taxes, and long-term you should beat actively managed funds. But there’s a new kid in town - so-called ‘enhanced’ index funds.
Enhanced Index Funds
An index fund invests to match, as closely as possible, the broad market represented by an index like the S&P 500 or Russell Wilshire 5000. (How’s that for a circular definition?) The classic dig on index funds has always been ‘you can’t ever beat the market in an index fund.’ True enough and that’s where enhanced index funds come in.
An enhanced index fund tracks the index but also uses mathematical models to try to overweight certain stocks in the index in an effort to goose returns. Different funds do it in different (and undisclosed) ways. The investor doesn’t much care as long as it works.
In return for this effort, you are charged slightly higher management fees. For example, the Vanguard S&P 500 index fund (VFINX) has a management fee of 0.18% while the Value index fund (VIVAX) has a 0.21% fee. Here are some historical data on Vanguard index funds.
Worth It?
So the bottom line question is - are enhanced funds worth it? Probably not.
First, it’s really too early to tell, since most of these enhanced funds are new. The few that have been around for years represent too small a sample to evaluate, in my opinion.
Second, there’s not much of a difference I can see - either in holdings or fees. In the Vanguard example above the fee difference is a whopping 0.03%. It’s difficult to tell exactly what the weightings are from the prospectus and annual report.
With an true index fund, you know exactly what you’re getting - the index minus a little bit. With an enhanced, there’s no guarantee you’ll beat the index and you could under-perform.
Besides all this analysis, I have to ask: what’s the difference between an enhanced index fund and a tax-managed active fund? Aren’t the stated objectives of both to beat the broader market index? Seems to me, when you add the word ‘enhanced’ to the front of ‘index fund,’ it’s no longer an index fund.
June 15th, 2007 at 8:31 am
Interesting, I hadn’t heard of these before. I have to admit though, I am a bit skeptical as well. It’s an interesting concept, to add in some functions which will play to the current market strength’s, but I think the stock market is just too complex to have a computer start trying to mimic the decisions of a fund manager. It’s worth keeping an eye on though.
June 15th, 2007 at 9:52 am
I agree - I’ll be interested to see if these fizzle out or gain in popularity. If it’s the latter, will the face the same problem all actively managed funds do in finding enough opportunities for all the money coming in?
June 15th, 2007 at 12:36 pm
I dunno if I would consider the Value Index an “enhanced” index but if we consider that as so, using it gives you the ability to rebalance at a detail level. Let’s take an example — say you bought the EAFE in 1980 and held until now. Well Japan had a huge market peak up to 91 and followed with a major recession where Japan is finally starting the uptick again. Since the EAFE is based on market cap weighting, your holdings would not have changed in terms of the specific companies or countries. So your EAFE fund would have zoomed up in 91 and then spent the next half a decade dropping and dropping until the recent Europe boom. Now if you had sliced and diced into two different indexes — EAFE Europe and EAFE Japan and rebalanced every year at 50:50, you would have taken a big chunk of profit from Japan in 91 and dumped it into the underperforming Europe market at cheaper shares. That would alleviate the 15 year Japan decline and the extra shares in Europe would have been an even bigger bonanza from the Europe upturn. And now you would be taking profits from Europe and moving into Japan right during the time Japan’s market recovery seems to be starting.
So instead of holding the S&P500, you hold Large Value Index and Large Growth Index. The fees are slightly higher and while holding them 50:50 gives you roughly the same holdings as the S&P500, the disparate growth rates between the two allow you to capture profits from the boom & bust cycles. Again a very good example would have been the dotcom boom/bust. Growth funds were huge during that time. If you hold just the overall cap-weighted index, you would have seen a big rise and then a big drop and finally return to 2000-levels about 5 years later. Splitting the index into two would have let you skim profits from growth, dump into underperforming value and probably return to your peak in a good 2 or 3 years earlier as value has outperformed growth the last 5 years by a huge margin.
Beyond the rebalancing issue, there’s a whole slew of research and data that shows small & value has historically outperformed large & growth. (Google up Fama French 3-Factor Model.) So if you believe the numbers that show index funds outperform actively managed funds, why wouldn’t the historic numbers for small & value be just as compelling. Hold the total stock market, then add enhanced indexes that give you small & value.
June 15th, 2007 at 2:41 pm
“the broad market represented by an index like the S&P 500 or Russell 5000″
There is no Russell 5000. There is a Russell 3000 and there is a DJ Wilshire 5000.
The Vanguard Value Index Fund is not an enhanced index fund. It’s a straight index fund. It just tracks a different index. An enhanced index fund would be something like PIMCO StocksPLUS Total Return Fund Inst (PSPTX) which invests in “S&P 500 derivatives, backed by a portfolio of fixed-income instruments.” Or something like one of those new funds launched by Fidelity recently. See http://content.members.fidelity.com/Inside_Fidelity/fullStory/1,,7460,00.html.