Enhanced index funds

Enhanced index funds and quanititative or “quant” funds, while not replication funds, build on traditional indexing strategies and are playing an increasingly important role in many institutional and individual investors’ fund portfolios.

An enhanced index fund attempts to outperform its underlying index using a variety of strategies. For instance, the fund might seek higher returns by identifying the undervalued stocks in the index, allocating a greater portion of the fund to stronger-performing sectors, or buying derivatives on the underlying securities. These funds use traditional research and management, complex computer modeling based on quantitative investment analysis, or some combination, to select securities within the index.

Enhanced funds try to beat the index by a very small margin — from a fraction of a percent to two percentage points — since a spread wider than that maximum would classify them as actively managed funds.

While enhanced funds offer the potential for marginally higher returns than traditional replication funds, there is also the risk that they will underperform their benchmarks. Plus the expense ratios for enhanced index funds may be more in line with actively managed funds than passively managed replication funds. So if you are considering purchasing an enhanced fund, it’s smart to weigh whether the additional return you might achieve is worth the additional risk you would be taking plus the potential for added costs.

One active trading technique that is index-related is to buy stocks that are about to be added to an index. Investors who use this strategy anticipate that the price of the stock will go up when fund managers are required to buy the stock to ensure their fund is in line with the new composition of the index.

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