Enhanced Or Active?
Precisely Defining Enhanced Endexing and Risk-Controlled Active Management
by: Steven Schoenfeld and Joy Yang
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Few areas of investment management are as misunderstood (and often misclassified) as enhanced indexing. For an investment approach that stresses precision, this is quite ironic. Yet despite this hindrance, this type of investing has been growing dramatically around the world, particularly in the bearish early years of the new century. In this article, which is a streamlined version of a chapter in the forthcoming book, Active Index Investing, to be published by John Wiley & Sons in March 2004, we aim to refine the definition of enhanced indexing.1
This article proposes a new segmentation between what we consider “true” enhanced index strategies and risk-controlled active approaches (which commonly get tossed into the enhanced indexing definitional category). We believe that a clearer, more precise definition of both areas will benefit asset owners and investment managers, as it will lead to more appropriate performance universes and comparisons. Given the logic and value of both of these approaches, this can only lead to more growth in both areas as well as clarifying the way services provided by risk-controlled active managers should be measured.
Enhanced Indexing Comes Of Age But The Definition Gets Blurred In The Process
The steady and accelerating growth of enhanced indexing products is partly the result of both disappointing active manager performance and increasing allocation to index based strategies as a core component of overall equity allocation. At the end of June 2003, over $325 billion was allocated to enhanced index strategies by U.S. institutional tax-exempt investors—approximately 20% of all index-based assets.2 Furthermore, it is not just fund managers but also asset owners who are adapting this approach. For example, Norges Bank Investment Management an arm of Norway’s government which oversees management of the State Petroleum Fund —initially used only external index managers. However, in early 2000, they brought a substantial amount in house, and by the end of 2001, approximately 7 billion euros (US$8.2 billion) was being managed in an enhanced index framework.3
As it is generally understood in the investment management industry, enhanced index strategies are investment approaches that aim to outperform a benchmark index within predetermined risk and return parameters. This kind of definition leaves a lot of room for interpretation, and if one asks a few dozen investment managers, Plan Sponsors and consultants, one is very likely to get a very wide range of definitions. Should the enhanced indexing designation which drives numerous Plan Sponsor searches encompass traditional, fundamental, active techniques that have been “toned down” by risk controls? Or should the industry aim to dig deeper into how the alpha is produced? This would create the complexity of greater segmentation between enhanced indexing and risk-controlled active, yet yield increased clarity.
With those questions in mind, the objective of this article is threefold. We will appropriately classify the EI space, which in our opinion lies between index and risk controlled active in the risk spectrum. This classification encompasses a more granular segmentation of alpha, with subdefinitions for “index alpha” and “active alpha.” We then identify the different types of enhanced index strategies that can be used.
Classifying Enhanced Indexing On The Passive-Active Spectrum
Enhanced indexing has two basic goals in relation to both active management and passive management: to outperform the index while maintaining the risk characteristics of the index. The first objective, to outperform the index, requires a robust and stable alpha that is consistent over different investment cycles and sustainable over time. The second objective, risk containment, naturally constrains the first objective to a modest level of excess returns, especially when compared to traditional active strategies.
The industry’s generally accepted definition of an enhanced index fund is that it is a strategy that seeks to outperform an index benchmark by less than around 1.5% with tracking error of less than 3%, usually lower. As such, enhanced indexing is often considered a superior form of investing because it leads to more consistent performance with minimal turnover and low transaction costs. The combination of active and index management draws upon the best of both investment strategies. Enhanced indexing requires the skills needed to identify and maintain alphas, combined with the expertise required to understand the index. The resulting benefit of the nexus between active and index techniques in successful enhanced index strategies is the potential for high information ratios.
The information ratio summarizes the risk and return properties of an active portfolio to access performance relative to a benchmark. It can distinguish between the skilled portfolio manager, who achieves outperformance with relatively little risk, from the “cowboy” portfolio manager who achieves outperformance through very high risk strategies.4 It can also differentiate between strategies that have the opportunity to achieve greater outperformance relative to a benchmark by examining the number of bets it takes away from the benchmark. Mathematically, the information ratio is the ratio of expected residual return to residual risk. By definition, the benchmark portfolio and the risk-free portfolio have an information ratio of 0. Through empirical evidence presented by Grinold and Kahn, investors can use information ratios to assess skill and consistency of active (and enhanced) managers. In their framework, an information ratio of .50 is “good,” 0.75 is “very good,” and 1.00 is “exceptional.”5 All investors seek the highest information ratio possible, and all portfolio managers seek to maximize information ratio. Given its low-risk (low tracking error) characteristics, enhanced indexing has a natural potential for high information ratios. However, remember our initial assertion: The magnitude of the deviation from the underlying benchmark in a portfolio’s return is directly related to the number and size of the bets made by the manager, whether those bets are made through stock selection, synthetic derivative exposures or fixedincome duration bets.
Despite the industry’s willingness to accept definitions based on past or targeted performance, we do not believe that enhanced indexing should be defined by ranges of expected alpha and risk. Figure 1 graphically illustrates the industry’s current position on enhanced index strategies. On one end of the spectrum, we find passive (or index-based) management; on the other, traditional active management. We define passive management as a portfolio technique constructed to match the assets and activity of an index with the objective of replicating the index return.6 We define active management as a portfolio technique that takes explicit bets away from the index (and therefore adding risk) with the objective of outperforming the index/generating alpha. Enhanced indexing (EI) lies relatively close to passive strategies and falls within the linear spectrum between passive and active strategies. The much-misunderstood risk-controlled active (RCA) approach falls just to the right of EI, and the distinction between EI and RCA is often blurred.
FIGURE 1 – Current Definitional Framework for Enhanced Indexing

More appropriate would be a definition based on the actual investment techniques employed by the manager, not the expected results (which investors should know may not be an indicator of future performance). In some ways this is similar to the convention of defining active managers as value or growth managers. Thus, we propose the following functional, descriptive definition, one that appropriately distinguishes between enhanced indexing and risk-controlled active (as well as fundamental, traditional active) techniques:
Enhanced indexing employs technical and structural strategies in the capital market to systematically deliver outperformance of benchmarks with minimal additional risk/tracking error. “Index alpha” can be created by aggressive trading of index changes, blending cash and derivative market exposures, tax-arbitrage or tax-loss harvesting, or actually going outside the target asset class to exploit inefficiencies in the markets.
In contrast, we would define “active alpha” to be many of the strategies with low expected alpha and low predicted tracking error, which currently get lumped into the enhanced index category as risk-controlled active. We propose the following definition: Risk controlled active strategies employ fundamental equity analysis (whether quantitative or traditional) to outperform the asset class with tight, benchmark-linked risk controls, and aim to consistently deliver high information ratios. Some firms in the industry refer to these approaches as “structured active,” which we believe is equally appropriate.
The proposed definition of enhanced index would revise the current two-dimensional illustration of enhanced indexing with the Figure 2. The active-risk spectrum is broadened into a multi-dimensional spectrum as we employ strategies outside of the equity framework. As managers seek to enhance the investment by adding value over the benchmark return, they move away from the passive strategy point along the risk dimension as well as the asset class opportunity, including synthetic equity exposure (“synth”) and fixedincome duration bets (“F.I.”). This shift opens up the opportunity set for enhanced index strategies and enables the achievement of increased information ratios. However, note that EI opportunities are not limitless; the boundary of opportunities is limited by the cap on outperformance target, moving to the right along the spectrum. This EI space is both similar to and differentiated from low-risk active management, in its objective to control risk by replicating specific characteristics of the benchmark. As such it controls unintended bets against the index. However, RCA generally seeks fundamental sources of alpha through quantitative means, while EI seeks what we call “technical” and/or capital market alpha, often outside the asset class of the index benchmark. Both the risk target and alpha delivery delineate the boundary between enhanced index management, risk-controlled active (RCA) and traditional active management, as portrayed in Figure 2.

TABLE 1 STOCK-BASED ENHANCED INDEX STRATEGIES
Securities-based Alpha / Theory / Trading strategy / Risk
Convertibles Arbitrage / Equity-linked securities issued by same company will converge in relative price/value. / Sell the stock; buy the convertible. / Interest rate risk, credit risk tracking error risk.
Pairs Arbitrage / Mean reversion—two positively correlated securities with temporary deviations will ultimately revert back to normal relationship. / Sell relatively overvalued stock;buy relatively undervalued stock. / Breakdown in fundamental established relationship or historic correlation.
Dividend Enhancement / Differential dividend treaties between countries result in differential asset valuations for investors. / Sell stock to a tax-advantaged investor; buy instrument that maintains exposure in the sold stock; Share tax pick-up. / Tax regulatory changes, credit risk, execution risk, tracking risk.
Mergers & Acquisitions / Empirically, a spread is typically observed between the market price of the target company and the offer value of the stock. This spread theoretically reflects the risk associated with the completion of the M&A. / Sell the relative over-valued stock (the acquirer); buy the relative under-valued stock (target). / Deal breakup, regulatory intervention, index action, timingrisk.
Share Offerings / If an IPO or privatization is likely to be in high demand, and an index inclusion will be treated in a unique way, manager could add value by buying the new offering prior to index inclusion. / Buy stock at offering, hedging any additional market exposure; use lower acquisition price to add return once stock is added to index. / Fall off in demand, unexpected market moves.
Index Add/Delete / Imbalances in supply and demand create short-term pric- ing pressures that cause adds to outperform and deletes to underperform the index around adjustment date. / Buy/sell stocks in alignment with anticipated trading flows. / Anticipated trading flow and resulting price impact does not materialize, unintended bets in offsetting trade, stock-specific risks.
Tax-Loss Harvesting (for taxable accounts) / As an index strategy is agnostic as to alpha potential for individual stocks, systematic tax-loss harvesting and substitution with stocks having similar factor exposure will deliver incremental after-tax outperformance, with relatively small additional tracking error. / Sell stocks in sectors/cap-ranges that have experienced losses in given period; sell only when tax loss benefit to client exceeds T-cost of sell + substitute buy by 3x or more; replace with securities having similar factor risk(size, sector). / Strategy works best with portfolios substantially smaller than full-replication, thus initial portfolio construction and choice of substitute stocks can create significant tracking error, and PTE estimates may not be as accurate.
Portfolio ‘tilt’toward high dividend yielding stocks / Generally suitable for tax exempt investors such as pension plans. Tilting portfolio toward higher yielding stocks,while aiming for similar tracking to benchmark. / Conduct dividend screen and establish hurdle for overweight ing high dividend stocks; implement with extensive optimization to minimize tracking error to untilted benchmark. / Higher tracking error than standard index portfolio, potential changes in corporate dividend payout rations, potential changes in government tax policies.
The broader search for technical/capital market alpha leads enhanced indexers into the outer reaches of the ‘oval extension’ in Figure 2. The RCA approaches stay within the asset class spectrum, and fall further along the risk spectrum, moving closer to Traditional Active.
We believe that it is imperative for the industry to move toward greater definitional clarity.
It may not occur exactly along the line that we propose, but we do believe that it makes sense. Furthermore, as enhanced indexing/risk-controlled active strategies proliferate and grow in assets it is inevitable that the industry will slice and dice the category, and we will hopefully end up with a more precise definition. While we do not expect the industry to suddenly adapt this narrower definition of enhanced indexing, we do believe it is worthy of consideration and we will focus much of the rest of the essay on describing and explaining the types of enhanced indexing that falls within this narrower definition.
Defining The Types Of Enhanced Index Strategies And Their Relative Attributes
Using our definition cited above, sources of properly defined enhanced indexing strategies fall under two broad categories: securities-based strategies and derivatives-based strategies. Each method attempts to exploit a different form of capital market imperfection and inefficiency. They also seek to take advantage of index methodology idiosyncrasies and/or capital market inefficiencies. We detail the variations within the broad categories.
Securities-based enhanced indexing strategies
Securities based strategies rely on a diversified portfolio of stocks to replicate the risk characteristics of the index, and they exploit alpha through relative-value mispricings or event-driven opportunities. In a relative-value situation, the alpha source comes from temporary price deviations between two securities with an established relationship or historic correlation. This category includes convertibles arbitrage, pairs arbitrage and dividend enhancement. Event-driven opportunities arise from corporate restructuring situations such as mergers and acquisitions, share offerings and index changes such as add and deletes or index reconstitutions.