Beating Benchmarks, Even a Bit, Is Tough

January 01, 1999

Enhancing something is supposed to improve it. So 'enhanced index' mutual funds ought to be better than plain-vanilla index funds. That's the concept, anyway. But the performance of this quirky breed of funds isn't living up to the marketing pitch. For the 12 months ended in February, the average enhanced index fund pegged to the Standard & Poor's 500-stock index logged a 17.05% total return, while the pesky S&P500 index registered a significantly heftier 19.74% gain, according to fund tracker Morningstar Inc. Over a three-year period, the gap is also about 2 percentage points per year.

Looked at from another direction, just 24% of the enhanced index mutual funds have beaten their benchmarks over the past 12 months, and only 11% outperformed their respective indexes over a three-year period.

But before discussing what's wrong with this picture, just what is an enhanced index fund, which can also be known as an 'index plus' or 'disciplined' portfolio?

The idea is that the fund manager will try to outperform by spotting undervalued stocks or bonds, by tilting the portfolio toward sectors of the index that have the best growth prospects, or by using complex financial instruments known as derivatives, including futures and options, among various other wide-ranging strategies.

While many of the funds use portfolio constraints to keep the performance close to that of the designated index, the various attempts to alter the portfolio can add more risk than that found in a straight-and-narrow index-based fund, analysts say. 'These are really actively managed funds,' as distinct from so-called passively managed index funds, adds Steve Lipper, senior vice president of fund tracker Lipper Inc.

And that brings us to what's gone wrong with many of these funds. It turns out many have been laid low by the same sorts of things that plague run-of-the-mill mutual funds, with relatively high costs high up on the list. Greg Lintner, senior consultant at Yanni-Bilkey Asset Planning in Pittsburgh, says a recent analysis of 95 enhanced stock index funds by his firm revealed that these funds boast an average expense ratio of 1.1% of assets. That is significantly higher than the 0.54%-of-assets expense ratio of the average index-based fund, a lean operation run by technicians focusing on efficient trading.

Lintner also found that the enhanced funds trade stocks much more often than the average index fund, turning over about 97% of the average portfolio each year. With the higher fees and trading costs, investors might find 'an implied drag,' Lintner says.

Some managers also have been hurt by the continued price appreciation of already-expensive stocks, a development that undermines formulas used by managers to spot inexpensive stocks, even as it helps to fuel the S&P500 index's rise, says Gus Sauter, who runs index funds at indexing king Vanguard Group, Malvern, Pa.

Nevertheless, 'This is going to grow enormously,' predicts Burton Greenwald, a mutual-fund consultant in Philadelphia. The message that a fund manager 'can tweak the index and do better… appeals to a vast group,' he says.

A J.P. Morgan spokeswoman says the firm's large-cap strategy has bested the S&P in all quarters since 1991 except for one, and the two-year-old J.P. Morgan Disciplined Equity mutual fund was up a solid 20.46% for the 12 months ended in February, slightly topping the S&P 500. The fund stuffs its portfolio with slightly heavier weight-ings of favorite stocks than the S&P500 index, its benchmark, calls for.

Another strong performer is Aetna Index Plus Large Cap, up 23.18% for the 12 months through February. Aetna's enhanced index strategy for individual accounts has beaten the S&Pin 21 out of the past 29 quarters. The Aetna fund sometimes makes industry bets on S&P 500 sectors.

But those with less-winning ways include MSDW Value-Added Market Series/Equity Portfolio, which trailed the S&P 500 in the 12 months ended in February by more than 17 percentage points. The underperformance came because the fund puts an equal amount in each S&P 500 stock, not a great approach when the top 20 S&Pstocks are driving gains.

(For an in-depth discussion of one enhanced index strategy, see p. 22)

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