Are enhanced index funds genuinely enhanced?

Posted by Robin Powell on September 28, 2021

Are enhanced index funds genuinely enhanced?



It’s hard to keep track of all the different product names the fund industry comes up with. And here’s another name to conjure with — enhanced index funds. Never heard of them? Don’t worry — nor had we until LARRY SWEDROE told us about them. So what exactly are enhanced index funds? And are they genuinely enhanced?


One of the major trends in the fund industry is the rising importance of passive (defined as systematic, transparent and replicable) investing. At the end of 2020, according to the Investment Company Institute, passive exchange traded funds and index funds accounted for 40 percent of the assets in long-term funds. The growth in passive investing has been fuelled by the evidence, as presented in The Incredible Shrinking Alpha, that the returns to investors from active funds on average underperforms those from passive funds and that there is no persistence of outperformance beyond the randomly expected — creating high hurdles for investors in selecting the active funds that outperform.

In response to the trend, fund sponsors have created a plethora of “enhanced” index funds. In order to determine if these funds offer better performance for investors or if they are simply a marketing gimmick for investment companies to lure investors into funds with higher fees, Edwin Elton, Martin Gruber and Andre de Souza, authors of the July 2021 study Are Enhanced Index Funds Enhanced?, examined their performance. They began by noting: “The popularity of this type of fund can be seen by the fact that in December 2020, enhanced index funds had $1.11 trillion under management. Perhaps of more significance is that during the previous ten years, assets under management of enhanced index funds grew at an average yearly rate of 12% per year, while mutual funds grew at an average annual rate of 8% per year.”


What is an enhanced index fund?

Elton, Gruber and de Souza explained that an enhanced index fund attempts to outperform a specific index while holding differences in risk close to zero over time. These funds typically use security analysis to overweight some stocks in the index, hold a small proportion of the portfolio in assets not in the index, or add some futures or options to the security holdings. Enhanced index funds differ from typical mutual funds in that they place constraints on the weights of the securities they hold or on the risk (relative to the index) of their overall portfolio. 

To identify enhanced index funds, they used both Morningstar and CRSP databases. They provided the example of the ABN AMRO Equity Plus Fund. After stating that it attempts to achieve return equal to or exceeding the return of the S&P 500 Index, it states its investment strategy: “It normally invests at least 80% of assets to correspond as closely as possible to the relative weightings of the index. With respect to the remaining 20%, the advisor typically selects stocks included in the index but adjusts the weightings in an attempt to generate superior returns.” 

Their data sample covered the period 2000-2019 and 123 enhanced index funds following 22 different indexes. In order to avoid survivorship bias, their data sample included all funds that existed during the period. In analysing returns, they considered performance relative to the benchmark index, adjusting for leverage (market beta greater or below 1) and accounting for exposures to the four Fama-French-Carhart factors (market beta, size, value and momentum). Following is a summary of their findings:

  • The average beta of enhanced index funds (1.000) was virtually identical to that of the average index fund and the indexes they track (0.998). However, while all categories of index funds had betas close to 1, this pattern was not true for enhanced index funds. Average betas for enhanced index funds varied from 0.962 for bond index funds to 1.013 for small- to medium-sized index funds.
  • Enhanced index funds had an average r-squared value of 0.94. The r-squared value was lower for two categories of enhanced index funds: enhanced foreign equity index funds (0.87) and enhanced bond index funds (0.92).
  • Enhanced index funds outperformed index funds on a gross (pre-expense) basis — 44 basis points per year, statistically significantly different from zero at the 1 percent confidence level — providing evidence of manager skill. However, much of this excess performance was explained by beta levels with the prospectus index and sensitivity to the Fama-French-Carhart factors.
  • The pre-expense advantage of enhanced index funds all but disappeared post-expense because of their higher expense ratios. This was true whether using the low-cost share class available to institutional investors or the low-cost share class available to individual investors.
  • Institutional investor (net) returns for both index funds (-26.6 basis points) and enhanced index funds (-22.3 basis points) were less than the index they were attempting to match. 
  • Individual investor (net) returns for both index funds (-58 basis points) and enhanced index funds (-62 basis points) were less than for the index they were attempting to match.
  • Many enhanced index funds are consciously or unconsciously taking significant factor bets. On average, they gained from their bets on the four factors. The largest bet was on momentum, which helped performance, as did their bet on small stocks. However, their negative exposure to the value factor (a bet on growth stocks) hurt returns.    

Elton, Gruber and de Souza also examined whether an investor using well-documented evidence related to active fund performance could do better than the average enhanced fund. They examined common traits related to performance, including screening for lowest expense, lowest and highest turnover (how active the fund was), and prior year performance. They found that “almost no ability from any selection criteria we examined to produce above-average performance.” Importantly, they also found that “even when the selection rule improves performance compared to the average fund, the improvement is not enough to produce performance higher than the index.” And finally: “For the best predictor (expenses), the index fund selected not only outperforms the average index fund, it also outperforms both the average enhanced index fund as well as the enhanced index fund selected using this criterion.”

Their findings led Elton, Gruber and de Souza to conclude: “While index funds and enhanced index funds have almost identical performance after fees, reasonable investors who selected index funds with low expenses would outperform enhanced index funds in general and enhanced index funds with low expenses.”

Their findings of gross outperformance that disappears after expenses is consistent with the theory proposed by Jonathan Berk and Andrew Green in their seminal 2004 paper, Mutual Fund Flows and Performance in Rational Markets. Berk and Green explained why it is hard to find persistent outperformance: “Investments with active managers do not outperform passive benchmarks because investors competitively supply funds to managers and there are decreasing returns for managers in deploying their superior ability. Managers increase the size of their funds, and their own compensation, to the point at which expected returns to investors are competitive going forward. The failure of managers as a group to outperform passive benchmarks does not imply that they lack skill. Furthermore, the lack of persistence does not imply that differential ability across managers is unrewarded, that gathering information about performance is socially wasteful, or that chasing performance is pointless. It merely implies that the provision of capital by investors to the mutual fund industry is competitive.”

Elton, Gruber and de Souza’s finding that the benefits of manager stock selection skill shown in gross outperformance went to the managers, and not to investors, is also consistent with the findings of other studies, such as the 2020 study Measuring Skill in the Mutual Fund Industry by Jonathan Berk and Jules van Binsbergen, and the 2021 study Yes, Virginia, there are Superstar Money Managers by Valentin Dimitrov and Prem Jain.


Investor takeaway

The takeaway for investors is that so-called enhanced index funds do not deserve the name. While there is evidence of skilful managers who are able to generate gross alphas for their funds, neither institutional nor individual investors are able to exploit that skill. All the benefits go to the fund sponsors in the form of high expense ratios and presumably to the star managers themselves in the form of compensation. Forewarned is forearmed.


Important Disclosure: The information presented here is for educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed.  By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured author are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. LSR-21-136


LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.



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Robin Powell

Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector.


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