The Basics of Enhanced Indexing

Enhanced indexing is a hybrid investment management strategy that attempts to gain the benefits of both passive management and active management. Index funds are designed to track the market as a whole; managers of these funds are passive in order to allow the fund to ride out ups and downs while reducing transaction costs. On the whole, passively managed funds are generally considered to offer the best diversification and protection against risk. Through enhanced indexing, this model is slightly adapted, allowing transactions to take place for a fund, ideally, to beat the benchmark index.

Index Investing Benefits

The goal of index investing is simple: keep it simple. The market is already efficient, according to this theory, so all you have to do to eventually turn a profit is track the market. To track the market, you can track a market index. Popular indexes include the S&P 500, the NASDAQ composite and the Amex composite, to name a few. A fund tracking one of these indexes would hold shares in the underlying securities listed on the index. Even when one of the securities took a hit, the fund manager would not act immediately, attempting to allow the market to ride the wave and reduce any transaction cost.

Actively Managed Fund Benefits

An actively managed fund does not track a particular index. Instead, the fund manager makes decisions on which securities to purchase based on financial modeling. Often, the fund uses performance or dividend-weighted modeling to make decisions on the best securities available at a given time. If a security fails to perform, the manager may immediately switch gears, choosing a new option. This results in a transaction cost to the investor. However, investors in these funds believe the costs and risks are worth potentially higher earnings. It should be noted that these funds do not necessarily outperform passive index funds.

Enhanced Indexing Benefits

Enhanced indexing attempts to bring together the best of both worlds. The idea is that an indexed fund is essentially efficient, but it needs a slight adjustment every now and then to maintain this efficiency. The option still tracks an index, hoping to follow market performance. However, it adjusts this index slightly in order to actually outperform the benchmark index. Risk levels should remain relatively low despite the slightly larger amount of activity on the fund. The idea sounds solid, but there is again little proof that enhanced index funds perform better on the whole than other index funds. The performance is related to how well the manager anticipates changes in the market.

Example of Enhanced Indexing

In an enhanced index transaction, the goal is to unload low-value stocks and reinvest in high-value stocks. One way to do this is short sell a stock on the index the fund manager believes is currently overvalued. If the manager is right, the proceeds from the short sale are then reinvested in a stock on the index the manager believes is undervalued. The result should be higher returns than if the fund were equally invested in both options.

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