| Enhanced Indexation 101 |
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| 27/06/2004 | |
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Analysts at Merrill Lynch Investment Managers in London detail the enhanced index strategy in this week's 101. Providing an interesting alternative to a pure indexing strategy, enhanced indexation has been increasingly sought by investors in recent times to spice up their passively managed assets without entirely losing its risk-neutral quality. 1-What is enhanced indexation? Due to its growing popularity, in recent years the term "enhanced index" has been used as a label for many different strategies. Broadly, enhanced indexing is a strategy that seeks to modestly outperform an index, whilst retaining the essential risk (and more importantly return) characteristics of that index. A quick overview of the enhanced index marketplace reveals that methods for achieving outperformance vary from one manager to the next. Strategies carrying the label of 'enhanced index' range from quantitative products with active risk levels (around 2% or even higher), which may more accurately be termed active quant, to products that are essentially scaled-down versions of traditional fundamental active, to derivatives based 'synthetic' strategies, which utilize index futures combined with aggressive cash management. At MLIM we construct enhanced index portfolios which seek to closely track their benchmark indices while applying quantitative stock selection and stock substitution strategies to generate outperformance. 2-What is the main difference with a regular indexation strategy? What about its benefits and downturns? Enhanced index strategies offer a good alternative to traditional passive index management, adding the potential to outperform the index whilst only marginally varying the characteristics of the index. It offers many of the benefits of traditional passive index management, such as low fees and diversification. The primary downturn to enhanced indexing is that enhanced index strategies experience greater volatility of returns relative to the index than passive index strategies. This volatility, however, is generally low compared to active strategies and can be necessary to create the opportunity to outperform. 3-What are the benefits of buying into an enhanced index for an institutional investor? Is it relevant for all institutional investors or are some characteristics required from the investor to get all the benefits from such an investment? For an institutional investor, we believe there are two main reasons for buying into an enhanced index strategy: 1) as an alternative to pure index management with favorable characteristics, or 2) to improve the overall efficiency of a manager structure with active and passive elements. With regard to the first point, the investor gains the positive attributes of a passive index strategy while offering the potential for out-performance with relatively minor risk of under-performing the index. When examining enhanced indexing in the context of the total portfolio, this apparent increase in risk is much less significant. When considered in the light of practical risk measures, such as the probability of under-performing a given threshold, including enhanced indexing may actually reduce risk whilst increasing expected return at the portfolio level. In addition, enhanced index products are often available on a performance-fee basis, which creates the advantage of paying higher fees only if out-performance has been achieved. Since enhanced indexing is competing against a low-fee alternative in traditional passive index products, a base fee at a level similar to passive indexing combined with a fee payable only on outperformance can be a very useful feature. Interview by This e-mail address is being protected from spam bots, you need JavaScript enabled to view it |
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Articles of the same Serie : 101 |
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Articles of the same Topic : Portfolio management |
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