Enhanced index fund management represents almost 20% of the more than $500 billion in institutional, tax-exempt indexed assets of the leading index fund managers.
While sponsors continue to use passive indexing as an important component of their equity portfolios, they also are using enhanced strategies, a decidedly active indexed portfolio, to better the market.
These enhanced index funds lie somewhere in the gray area between traditional active and passive management, offering to better the benchmark index to which they are tied while being constrained to the risk level of that index.
One reason pension executives are switching to enhanced indexing from strictly passive investing is the need for better returns, said Bob Garvey, president and chief executive officer of INTECH, Palm Beach Gardens, Fla. INTECH's mathematical enhanced index product, started eight years ago, has $4.219 billion as of Sept. 30, up from $494 million in January 1991.
Rick Nelson, vice president and head of structured equity at J.P. Morgan Investment Management Co., New York, said there is an upswing in searches for enhanced index fund managers.
He said some pension executives want to "upgrade" their index funds; others are disenchanted with traditional active management and are looking for more consistent returns.
J.P. Morgan introduced the first of its two enhanced indexed portfolios in 1989 with $150 million. Assets have grown to $5.2 billion, of which $3.2 billion is for U.S. institutional tax-exempt clients.
So what are enhanced index funds and how do they work?
"The definition is a moving target," said John Loftus, executive vice president at Pacific Investment Management Co., Newport Beach, Calif.
In 1987, he said, enhanced indexing meant index arbitrage, which took advantage of the inefficiencies between the pricing of the Standard & Poor's 500 Stock Index and S&P 500 futures. He said those opportunities since have disappeared, and today's money managers are using derivatives, bottom-up and top-down stock picking in their enhanced index fund offerings.
Mr. Loftus described PIMCO's derivative-based enhanced index fund as "a bond product in equity clothing," because the strategy uses S&P 500 index futures and actively manages short-term fixed-income investments to enhance returns.
Assets in the approach have grown to $7.1 billion as of Sept. 30, from $709 million in 1990. New cash comes about equally from active and traditional passive strategies, Mr. Loftus said.
Even though enhanced index fund managers use different strategies and some don't even consider themselves indexers, most agree on some basic qualities of enhanced index portfolios - controlled risk and close tracking of an index.
J.P. Morgan's Mr. Nelson said enhanced index funds typically have a low tracking error, 2% or less of an index benchmark, and are built with risk control in mind.
Stock-based strategies outnumber derivative-based strategies four-to-one, said Mr. Nelson.
Although J.P. Morgan manages $8 billion in its two enhanced index strategies, it considers itself an active manager, not an index fund manager. By their nature, enhanced index funds are active, Mr. Nelson said.
While traditional active management aggressively overweights sectors, J.P. Morgan's enhanced index funds match the sector weighting of the S&P 500, he said. Managers add value not so much by what they leave in, but what they eliminate - overvalued securities - from the S&P 500.
Stock selection however is not limited to those listed in the S&P. Of J.P. Morgan's two products, the more conservative carries about 350 stocks and the moderate, 250.
Fees for enhanced equity index fund management range from as little as 20 basis points to as much as 65 basis points, depending on the level of active management and the size of the account. In many cases, enhanced index fund managers use the same level of fundamental research as a firm's traditional active portfolios.
INTECH and PIMCO use performance-based fees. In one case, INTECH guarantees a return of 25 basis points net of fees annually on three-year contracts, through its parent, Prudential Insurance Co. of America.
Recently INTECH started offering what Mr. Garvey refers to as a "jumbo account initiative." to its performance-based fees. One of its aims is to attract larger accounts between $1 and $2 billion, he explained. In one of the options, the client retains up to 50 basis points of annual excess performance vs. the S&P 500, plus 50% of any additional excess, with the remaining 50% being the fee. In the second option, the client keeps the first 90 basis points of excess performance, with anything over going toward management fees.
By contrast, fees on "plain vanilla" indexing would be around 10 basis points, said Ed Madden, vice chairman of Fidelity Management Trust Co., Boston, although he has heard of them being as low as one or two basis points.
Almost all of the indexed assets Fidelity manages for institutional tax-exempt clients are in enhanced index funds. On May 31, $11.069 billion of its $11.989 billion in indexed assets were in enhanced index funds.
"We are not in the index business," said Fidelity's Mr. Madden, "but we can run an index."
Fidelity uses stock selection based on the research and analysis of the same portfolio managers who manage its traditionally active strategies.
Fidelity has 17 enhanced index portfolios and one mutual fund. Mr. Madden said lifestyle funds for defined contribution plans also are using the firm's enhanced index funds.
State Street Global Advisors, Boston, manages both passive and active investments. Peter Stonberg, chief investment officer, said anything that is managed against a benchmark can be an index fund. His definition of enhanced indexing places it somewhere between passive strategies that match a benchmark in performance and full active strategies that add value and volatility levels.
Enhanced index portfolios, he said, add a small amount of value and some volatility.
Mr. Stonberg said State Street uses the same research and analysis for its enhanced index funds as it does for its active portfolios, then tunes back the risk. They hold, for example, smaller positions in more securities and hold certain characteristics closer to the market.
State Street also manages a large enhanced bond index portfolio. He explained that it is more difficult to mirror the securities in a bond index. The enhanced bond index picks up basis points by the selections its portfolio managers must make in order to create the index fund.
But Mr. Stonberg sees the growth in enhanced index funds as modest at best. He sees more growth in traditional passive and active strategies.
Investment management consultant Evaluation Associates, Norwalk, Conn., recently completed an analysis of passive and enhanced indexing - what it calls index-plus strategies - as alternatives to traditional active management. The report concluded that, in a full market cycle, active management can outperform passive management on a cost-effective risk-adjusted basis, but conceded there is a compelling case of passive or enhanced index portfolio management for the largest capitalization segment of the market.