Are Enhanced Index Funds Enhanced?

Edwin J. Elton is Professor Emeritus of Finance and scholar in residence at NYU Stern School of Business; Martin J. Gruber is Professor Emeritus of Finance and scholar in residence at NYU Stern School of Business; and Andre B. de Souza is Assistant Professor of Economics and Finance at St. John’s University Peter J. Tobin College of Business. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here); New Evidence, Proofs, and Legal Theories on Horizontal Shareholding by Einer Elhauge (discussed on the Forum here); and Horizontal Shareholding by Einer Elhauge (discussed on the Forum here).

One of the major trends in the mutual fund industry is the rising importance of passive investing. At the end of 2020, according to the Investment Company Institute, passive exchange traded funds and index funds each accounted for 40% of the assets held by all funds holding long-term asset The growth in passive investing has come about because of the evidence that the return to investors from active funds on average underperform those from passive funds and a belief that selecting the active funds that outperform passive funds is challenging for the average investor.

One of the responses of the investment community to this challenge has been the creation of enhanced return index funds. 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. Do enhanced index funds offer investors a better performing index fund or are they simply a marketing gimmick for investment companies to lure investors into funds with higher fees?

What is an enhanced index fund? An enhanced index fund attempts to outperform a specific index while holding differences in risk over time close to that of the index. These funds typically use security analysis to overweight a small number of 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 the typical mutual fund 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.

Since we are examining both index funds and enhanced index funds, we constructed two samples. For the enhanced index fund sample, we start with all funds that were identified as enhanced index funds by either Morningstar or CRSP and existed anytime over the period 2000 to 2019. We then eliminated all commodity funds, funds following a proprietary index, funds that were variable annuity funds or life path funds, funds that matched some multiples of an index (e.g., twice the index), funds that were long short funds, and funds that started in the last 12 months of our sample period.

After these eliminations our enhanced return sample consisted of 123 funds following 22 different indexes.

Our second sample consisted of all index funds following any of the 22 indexes followed by enhanced index funds. For each index, we selected all index funds that followed one of the 22 indexes and existed sometime over the period that some enhanced index fund existed.

In this paper, we take a specific approach to analyzing index funds and enhanced index funds. We assume that an investor analyzing an index fund and enhanced index fund is concerned with how they perform relative to the index it identifies in its prospectus as the index it intends to match. Furthermore we assume the investor is choosing between the two types of funds. For both index funds and enhanced index funds, we examine performance before fees (management performance) and performance after fees (investor performance). In addition, we decompose the overall performance of each type of fund into two parts: that which is due to bearing systematic risk with respect to the index (beta different from one), and that which is due to security selection. We then proceed to examine to what extent the return from security selection can be explained by market factors believed to give an excess return (small or value stocks).

When we examine returns pre-expenses, we find that enhanced index funds outperform index funds at a statistically significant level. Furthermore they outperform the index they follow (they add value). For enhanced index funds, much of this excess performance is explained by beta levels greater than one with the prospectus index (levering) and tilting to small stocks or value stocks. When we examine post expense returns (returns to the investors) enhanced index funds still outperform index funds but at an insignificant level. However, when we use well established rules for selecting the best fund from among all those following an index (such as picking the one with the lowest expense ratio) index funds have superior performance.

The complete paper is available for download here.

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