Enhanced S&P 500 Index Funds Require Selectivity

Feb. 23, 2004 -- So-called enhanced S&P 500 index funds, unlike conventional index funds, aim to beat their bogey, but as a group they fail. Still, some enhanced S&P 500 index funds have managed to outperform that benchmark in recent years.

Conventional S&P 500 index funds invest in the 500 with the goal of closely tracking that index's return. However, they lag the 500, due to trading and administrative costs. More recently, enhanced index funds have become increasingly popular with investors looking to boost their returns while still retaining some of the benefits of traditional index funds. While enhanced index funds also exist for indices other than the S&P 500, we will focus on funds using the 500 since the vast majority of enhanced offerings are based on that index.

As with traditional index funds, enhanced funds also invest in an index. However, these enhanced offerings aim to beat their benchmark's performance by overweighting exposure to certain stocks in the index that are viewed as undervalued, or by using futures and options, and then adding some fixed-income securities to the portfolio to generate additional income.

The primary advantage of enhanced index funds over straight index funds, at least theoretically, is, of course, the potential for better returns. Yet these enhanced funds still aim to maintain risk profiles relatively similar to their underlying index, thus enabling investors to add some return without significantly increasing risk. They also allow investors to maintain exposure to the benchmark index.

On the downside, they also have higher expense ratios than conventional index funds. The average expense ratio for traditional S&P 500 index funds is about 0.6%, while their enhanced counterparts run at about 1.2%. This, in part, reflects the higher trading costs these funds may incur in order to achieve higher returns. The increased trading activity is indicated by their sharply higher average turnover. While the typical S&P 500 index fund runs an average turnover ratio of about 12, the average for an enhanced S&P 500 fund is 179.

Enhanced index funds also have a sharply higher tracking error. The average S&P 500 index fund has a tracking error of about 0.2, compared to more than 1.7 for the average enhanced S&P 500 fund. While this would be expected, given that enhanced funds are deviating somewhat from the exact underlying index, it is still a key point for investors who are using indexing as part of their overall portfolio strategy.

The first table at the bottom provides average return and other figures for straight S&P 500 index funds, enhanced 500 funds, and the S&P 500 itself for the period ending Jan. 31, 2004. The second table lists the eight enhanced index funds (excluding multiple share classes) that beat the 500 for the year ended Jan. 31, 2004.

The eight funds in the table below not only beat the 500 over the past year, but were able to do so while maintaining relatively low expense and volatility in line with the 500. In fact, their expense ratios were not only well below the overall average for enhanced S&P 500 index funds, but were in line with those for conventional 500 index funds. Their additional returns over conventional index funds were therefore not completely offset by sharply higher expenses.

In addition, almost all of these eight funds beat the 500 over both the three-year and five-year periods. The only shortfalls were the three-year return for Metropolitan West AlphaTrak 500 Fund (MWATX), and the five-year return for Payden Market Return Fund/R (PYMRX).

As mentioned earlier, enhanced S&P 500 index funds have a higher tracking error, and these eight funds are no exception. However, they cover a fairly wide range, with the two funds mentioned above representing the high and low ends. The Metropolitan West AlphaTrak 500 fund posted the largest tracking error of these eight funds at 4.00, more than double the 1.73 average for enhanced S&P 500 index funds overall. At the other end of the scale, by far the best of the eight in terms of tracking error, was Payden Market Return fund at only 0.66.

One noticeable result in the tables below is that none of these funds are ranked higher than 3 Stars. For a fund to be ranked higher than 3 Stars by Standard & Poor's, it must outperform the three-month Treasury bill over the three year period ending January 31, 2004. While the broader equity markets rebounded sharply in 2003, their dismal performance in 2001 and 2002 dragged down the overall three-year performance of most mutual funds to the point where they lagged even the three-month T-bill.

Another factor to keep in mind is the exposure of the underlying S&P 500 index to various sectors. The financial and information technology sectors represent 21% and 18%, respectively, of the S&P 500's total market capitalization. Consumer discretionary and consumer staples follow at about 11% each. At the bottom, utilities represent the smallest sector at just 2.8%.

In terms of tax issues, enhanced funds' strategies can involve more trading, and so they can generate more capital gains than a conventional index fund. In addition, some enhanced funds invest in fixed income securities as part of their strategies, which will also create taxable income. As such, enhanced funds are generally less tax efficient than conventional index funds.

Also worth mentioning is that not all index funds whose objective is to outperform their benchmark are considered simply 'enhanced'. In addition to the enhanced category, Standard & Poor's also categorizes certain funds in its database as Index Bull or Index Bear. Enhanced index funds strive to achieve a modestly better return than their related underlying indices, while maintaining a risk profile relatively similar to the particular index. Conversely, index bull and index bear funds are far more aggressive. They look to achieve, for example, 125% to 200% of the benchmark's return, or minus the return for index bear funds, which short the market. They also have much higher expense ratios (2% - 3%), and their volatility is generally more than double that of a conventional index fund. "Index bull and bear funds give investors options for 'legitimate' market timing," says Standard & Poor's mutual fund strategist Rosanne Pane. "They can gear up or gear down their exposure to the S&P 500 based upon their own market outlook."

So for investors looking to boost their returns from an index investing strategy, an important point to remember is that as a group, enhanced S&P 500 index funds fail to beat the 500. However, that does not mean investors should avoid these funds altogether. Selectivity is the key. "Enhanced funds tend to be quantitatively-driven and seek undervalued growth opportunities", says Pane. "These funds do well when value is in favor."

The eight enhanced offerings listed below do, in fact, deliver, and a well managed enhanced S&P 500 index fund with a low expense ratio can be a good addition to a broader portfolio.

-- Kevin Gooley

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