The key to risk management oversight of enhanced index investment approaches is to not lump them together in one basket, industry experts say.
That's because enhanced index strategies can vary widely, with some versions taking on risks from more than one investment market.
But the complexity of the strategy hasn't slowed their growth among institutional investors. A recent tally by Pensions & Investments showed enhanced index assets among the largest index fund managers growing 14% in the six months ended Dec. 1 (P&I, Feb. 17).
Many in the industry group enhanced indexers into two basic investment categories.
One involves long-only investments in securities that seek to carry similar characteristics to the stocks in the index, but will produce a different return. A manager might tilt an enhanced index portfolio to carry more growth or value stocks than the index does, seeking to outperform the index.
The other broad type combines active management from one asset class, say fixed income, with the passive returns of another market, U.S. equities, usually using derivatives to do so.
The long-only stock or bond picker actually might be more easily controlled than a typical investment manager, from a risk standpoint, said Drew Demakis, managing director-research, RogersCasey & Associates, Darien, Conn. That's because that type of enhancement already is basically a risk-managed product, Mr. Demakis said.
But the other category of enhanced indexing, often called alpha transportation, is more complicated, consultants say.
Managers offer a wide, and growing, variety of styles in the effort to outperform a chosen index.
"Every couple of weeks a new strategy comes down the pike," said Mark Riepe, vice president for Ibbotson Associates, Chicago.
The key is in determining the source of the active management returns, Mr. Riepe said. For instance, a fixed-income enhanced index manager might lag the selected index in a down bond market, he said.
The appeal, however, is that a manager with a proven ability to outperform in one market can transfer that alpha to the index returns of another market.
Pacific Investment Management Co., Newport Beach, Calif., has been doing that in a limited partnership fund since 1986, and currently offers separate accounts and a mutual fund in the strategy as well.
Brent Harris, managing director, said that while PIMCO's enhanced stock index strategy might take a little more time to explain to potential clients, the "concept is so powerful" it's worth it.
PIMCO usually uses futures or swaps to gain stock index exposure, and collateralizes it with fixed-income securities with a maximum duration of one year. As long as the fixed-income portfolio outperforms the implied short-term yield in the derivative product, an enhancement will result.
PIMCO has added, on average, 150 basis points per year since 1986 to the Standard & Poor's 500 Stock Index, he said.
An instance where PIMCO might not outperform would be when the fixed-income yield curve shifts to an inverted position, where short-term rates are higher than long-term rates, from a previously normal position.
But once the shifting has occurred, PIMCO managers then should be able to restructure the portfolio to outperform, Mr. Harris said.
He added the strategy requires futures management skills.
Lotsoff Capital Management, Chicago, is another manager that uses fixed income to seek to enhance the returns of other markets.
Matthew Smith, managing director for Lotsoff, said the firm's managers invest two ways. They take on duration risk in the fixed-income market, but use duration puts and calls to lock in a return over a given period that is statistically likely to be positive.
Plus, the strategy is structured to strictly limit the amount of variation in the relative return.
Similarly, if Lotsoff managers can find international rates that are significantly higher than U.S. interest rates, they will invest there, but will try to hedge away the currency risk.
Lotsoff generally has produced about 200 basis points in excess return for the strategy, Mr. Smith said. Lotsoff has offered the style since 1989.
Other alternative types of strategies, such as options volatility management, also can be used to enhance equity returns.
But not all enhanced strategies have proven successful. Ibbotson Associates found in a 1996 study that enhanced index mutual funds often did not outperform or closely track their chosen index (P&I, Aug. 5).
Another study is under way, this time examining institutional managers. Mr. Riepe said the returns of the institutional enhanced index accounts are looking much better than in the first study, although there is broad dispersion in how well the enhanced strategies track their index.