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).