Adding a bit of zest

Enhanced indexing takes the basic promise of passive investing -- benchmark returns at a relatively low cost -- and then adds a dash of active management’s essential allure: outperformance. Properly prepared, an enhanced index is a modified version of traditional fare, like the Standard & Poor’s 500 index, that over time offers a slightly better return than the original. It achieves this gain by employing strict risk and cost controls and utilizing quantitative and fundamental research to make occasional wagers on stock price movements.

This concoction sells. Last year 28 percent of equity index placements among institutional investors in the U.S. were for enhanced strategy, up from 19 percent in 2001, according to Mercer Investment Consulting’s Tracker Database.

As more and more pension funds, foundations and endowments are consolidating their roster of asset managers, enhanced indexing offers an attractive middle ground between purely passive and active approaches. “A lot of the big institutional investors are looking for simpler approaches and fewer managers,” says Richard Ennis, a principal at Ennis Knupp & Associates, a Chicago-based consulting firm. “Enhanced indexing fills that bill.”

Often enhanced indexers like to emphasize their connection to the world of active management, which garners far more substantial fees than passive strategies. Enhanced indexing typically costs 28 basis points for a $100 million large-cap core account, according to Casey, Quirk & Acito, a Darien, Connecticut, consulting firm. That compares with 5 basis points for a pure institutional index fund and 44 basis points for an active fund. An enhanced index retail fund’s costs average about 100 basis points.

“We see ourselves as active managers,” says Ronald Kahn, a managing director of advanced strategies and research at Barclays Global Investors.

Like all active managers, enhanced indexers run the risk of betting on a stock that suddenly develops a problem, or betting against a stock that takes off. Once that happens, it can be difficult to get back on the index track. For that reason, enhanced indexers tend to make very small bets and follow tight risk controls to minimize their potential losses.

“It would take a lot of those bets to go wrong at the same time to lead to underperformance,” says Gary Dowsett, a senior investment consultant for Watson Wyatt Worldwide in the U.K. “An enhanced indexer is taking a bunch of small portfolio bets in a disciplined way.”

The world’s two largest asset indexers, Barclays, with $750 billion under management, and State Street Global Advisors, with $763 billion, also dominate the market for enhanced funds. Barclays oversees $96 billion in enhanced stock index funds, while State Street handles $14 billion. (That gap partly reflects the two firms’ different definitions of enhanced indexing.) State Street’s enhanced index assets doubled last year.

Mellon Capital Management, the No. 6 indexer, is making a concerted effort to bolster its enhanced stock index assets, which currently total $1.8 billion, out of a total of $65 billion in passive funds.

“We are known as a quantitative manager,” says Tom Hazuka, chief investment officer at Mellon Capital in San Francisco. “But I think of ourselves as an economic valuation manager. We look at the long-term value of different assets and compare that with the prices and make portfolio decisions based on those differences.”

European investors, who only embraced enhanced indexing in substantial numbers in the past few years, tend to think of U.S.-based powerhouses like Barclays and State Street for their enhanced portfolios. Says Simon Roe, senior portfolio manager at State Street in London: “European pension funds are coming on board. Everyone is searching for return where they can.”

In today’s volatile markets, enhanced indexers everywhere emphasize their risk controls. “The flow of assets will go to those firms that are very risk aware,” says Chris Acito, a principal at Casey, Quirk & Acito. “Call it a flight to quality.”

In straying from the benchmark, the manager makes carefully selected small bets, usually not shifting more than half a percentage point above an index weighting. “We aim to beat the index without sinking the ship,” says Mellon Capital’s Hazuka.

His firm’s $1.1 billion S&P 500 benchmarked portfolio, called Active Plus, usually holds about 250 stocks. The money manager’s strategy focuses on four factors: valuation, earnings quality, earnings variability and earnings momentum. When Mellon Capital makes a stock pick, several of these factors are usually driving the decision. Like other enhanced index funds, Mellon Capital avoids loading up in a few industries. “We don’t make sector bets,” Hazuka says.

So where exactly did Mellon Capital choose to vary its benchmark recipe? The firm did well recently with Golden West Financial Corp., a $65 billion-in-assets savings and loan based in Oakland, California. The money manager started overweighting the stock September 30, when it traded at $62.18 a share; it was up to $71.79 in early March.

In Mellon Capital’s models, Golden West scored well on earnings quality: Total loans grew at a 3.9 percent clip in the fourth quarter, much faster than the 1.6 percent rate of its nonperforming assets, and its net interest margin improved to 3.17 percent for 2002, up from 2.93 percent in 2001. Golden West also displayed earnings momentum. Annual earnings estimates steadily increased throughout 2002, and its weekly mean estimate among analysts never decreased throughout the year.

Mellon Capital declined to disclose the amount of its overweight, but the money manager bought the shares steadily during the fourth quarter, during which time the stock price rose 15.6 percent.

Although Mellon Capital’s Active Plus portfolio has lost ground the past three years -- how could it not in this market? -- it has consistently beaten the S&P 500. The index declined 9.1 percent in 2000, 11.9 percent in 2001 and 22.1 percent in 2002, while Mellon Capital lost 7.65 percent, 10 percent and 22.05 percent, respectively.

State Street’s enhanced index portfolio of 300 stocks has beaten the S&P 500 for seven consecutive years. Risk control is key, says Doug Holmes, a principal at State Street. “An active manager approaches the problem first with an eye towards generating significant excess returns,” he says. “An enhanced indexer approaches the problem as wanting to have a lot of risk control with some excess returns.” Bets typically range 10 to 30 basis points above the benchmark level for a given stock, but the portfolio will sometimes go more than half a percentage point above the index. “It really is about creating biases in the portfolio,” Holmes says.

In State Street’s opinion, J.C. Penney Co.'s shares will enhance the mix. State Street increased its weighting at the end of the third quarter of 2002 to 71 basis points, about 65 basis points above the S&P benchmark. The Plano, Texas, retailer improved merchandising and introduced some aggressive promotions, and the strategy paid off during the Christmas season, allowing the company to report comparable same store growth of 3 percent for November and December. Free cash flow is up. Although the shares traded in mid-March at $19, below the fund’s costs basis for the stock, Holmes is holding on. “The amount we’re overweight is not going to sink us,” he says.

The money manager has recently increased its position in Procter & Gamble Co., the Cincinnati-based home products behemoth, to 196 basis points, about 53 points above the benchmark. Company layoffs and factory closings in 2001 and 2002 have reduced expenditures, resulting in higher free cash flows, signaling a buy to State Street.

The stock hasn’t risen for the past six months, but Holmes is prepared to be patient, citing the fact that EPS numbers have increased for five consecutive quarters. “We are comfortable that this is a reasonable stock to own going forward.”

State Street uses a similar approach with its international portfolio of 800 stocks, versus the 1,400 equities of its benchmark, the Morgan Stanley Capital International world index. It increased its share in Japan’s Yamanouchi Pharmaceutical Co. Following the lead of a series of analysts’ upward revisions of EPS estimates last year, State Street started increasing its weighting of Yamanouchi in July to 7 basis points, about 3 points above its weighting in the MSCI world index. The stock recently traded for $27.05, well above State Street’s cost basis of $24.09.

Enhanced indexing models also offer the flexibility to eliminate certain ingredients. For example, Barclays has steered clear of Schaumberg, Illinoisbased Motorola. Shares of the electronic equipment maker recently traded for $8, down from a 2000 high of $55.

No one’s likely to miss a bitter taste like that.

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