Are enhanced index funds enhanced?

• Published date: 01 March 2022
• Author: Edwin J. Elton,Martin J. Gruber,Andre de Souza
• Date: 01 March 2022
• DOI: http://doi.org/10.1111/eufm.12339

DOI: 10.1111/eufm.12339

ORIGINAL ARTICLE

Are enhanced index funds enhanced?

Edwin J. Elton

1

|Martin J. Gruber

1

|Andre de Souza

2

1

Department of Finance, Stern School of

Business, New York University, New

York, New York, USA

2

Department of Finance and Economics,

Peter J. Tobin College of Business,

St. John's University, Queens, New

York, USA

Correspondence

Edwin J. Elton, Department of Finance,

Stern School of Business, New York

University, New York, NY 10012, USA.

Email: eelton@stern.nyu.edu

Abstract

One of the major trends in the mutual fund industry is

the rising importance of passive investing. One of the

responses of the investment community to this chal-

lenge has been the creation of enhanced return index

funds. In this paper, we examine the performance of

enhanced index funds and find that they outperform

index funds when we analyze both pre‐expense per-

formance (management ability) and post‐expense per-

formance (investor returns). However, when we use

any of several criteria that have been proposed for

picking the best fund from among those following

some index, index funds outperform enhanced index

funds.

KEYWORDS

enhanced index funds, index funds

JEL CLASSIFICATION

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1|INTRODUCTION

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 assets.

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The growth in passive investing has come about because of the evidence that

Eur Financ Manag. 2022;28:327–344. wileyonlinelibrary.com/journal/eufm © 2021 John Wiley & Sons Ltd.

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We thank Yakov Amihud, Jennifer Carpenter, George Comer, Clifton Green, Joel Hasbrouck, Bill Sharpe, Robert

Whitelaw, John Doukas and an anonymous referee for helpful suggestions.

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The Wall Street Journal (2019) reported a more extreme result stating that there is now more invested in passive

mutual funds and ETFs than active mutual funds.

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 110 billion under management. Perhaps of more

significance is that during the previous 10 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. The management of these funds attempt to construct a fund that

will approximate an index fund using securities they believe will have superior returns. If

management is skilled, then pre‐expense return on the fund should be higher than that of an

index fund following the same index. If management is unskilled, then the pre‐expense return

should be similar to the return on an index fund following the same index. Even if management

of enhanced index funds is skilled, post‐expense return (investor returns) may be better or

worse than the postexpense return on index funds. Differences in expenses between the two

types of funds can potentially destroy any advantage of management ability. The performance

of enhanced index funds is important to analyze as they are growing in number and size. One

investor we interviewed described enhanced index funds as the soup du jour on today's in-

vestment menu. Do they 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?

In this paper, we examine the performance of enhanced index funds and find that they

outperform index funds on the basis of pre‐expense performance (management ability). They

also outperform index funds on the basis of post‐expense (investor) returns, but by a much

smaller margin. The pre‐expense advantage of enhanced index funds all but disappears post-

expense because of their higher expense ratios. This is true whether we examine the low cost

share class available to institutional investors or the low cost share class available to individual

investors. However, when we use any of several criteria that have been proposed in the lit-

erature for picking the best fund from among those following each index, index funds out-

perform enhanced index funds.

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 zero. These funds typically

use security analysis to overweight some 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.

Two examples can be found in the description of the investment strategy of enhanced index

funds as reported by Morningstar. Mass Mutual Premier Enhanced Index Core states that the

investment strategy is one that seeks to outperform the total return performance of its

benchmark index, the S&P 500 index, while maintaining risk characteristics similar to those of

the benchmark. A second example is provided by ABN AMRO Equity Plus Fund. After stating

that it attempts to achieve return equal to or exceeding the return of the S&P 500 index, it states

its investment strategy: “It normally invests at least 80% of assets to correspond as closely as

possible to the relative weightings of the index. With respect to the remaining 20%, the advisor

typically selects stocks included in the index but adjusts the weightings in an attempt to

generate superior returns.”

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 is concerned with how it performs

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ELTON ET AL.