The Hindu Business Line : Enhanced Indexing: Active management with less risk

Investors have a choice of investing in index funds or active funds. There seems to a wide gap between these two investment-styles. Enhanced indexing fills this gap. Traders and HNIs can replicate such a portfolio using the spot and the derivatives market.

B. Venkatesh

Many investors want to take exposure to stocks that constitute the S&P CNX Nifty, as these stocks would typically lead the market during its upturn. Index funds provide a low-cost exposure to such stocks. The problem, however, is that index funds also take exposure to stocks that may underperform within the Nifty index. What if the investor wants to overweight likely outperformers in the index?

We recently structured portfolios for some clients that closely mirror the index and yet provide for some active bets. This article discusses the characteristics of such an investment style called enhanced indexing. It shows how traders can construct such a portfolio.

The large gap between passive and active management also provides mutual funds enough opportunity to offer such products to small investors.

Active management?

Passive management is about investing in stocks that constitute the benchmark in the same proportion as their weights in that index. Active management takes active bets based on some investment style.

Large-cap index funds and large-cap active style are, therefore, two ends of the investment spectrum. What if the investors want exposure to portfolios that take small active bets within the index constituents?

An active fund may not help because such funds also invest in stocks outside of the index constituents. Enhanced indexing, on the other hand, fits the requirement.

A portfolio manager of such a fund will be tightly benchmarked to an index, yet allowed to take small active bets on its constituents.

Take an enhanced index manager benchmarked to the S&P CNX Nifty. Assume that the portfolio manager has a positive view on Siemens, a neutral view on Tata Power and a negative view on ICICI Bank.

The portfolio manager will marginally overweight Siemens, buy Tata Power in the same weight as the index and marginally underweight ICICI Bank. The total proportion of underweights would equal the total proportion of the overweights. The marginal “tilts” generate small excess returns over the benchmark index.

Controlling active risks

Index funds are required to mirror the returns on the benchmark index. But open-end index funds suffer from “cash drag”. This refers to the lower return that the portfolio earns on cash held to meet redemption requests compared with other assets in the portfolio.

This “cash drag” forces index funds to deviate from the benchmark index. The tracking error measures such deviation. This is the difference in the returns between the portfolio and the benchmark index.

Enhanced index managers are allowed a higher tracking error to take small active bets on stocks. Controlling the tracking error enables the portfolio manager to control the risk relative to the benchmark index. That is why enhanced indexing is called risk-controlled active management.

It is important to understand that a portfolio will not have a tracking error simply because a portfolio manager has generated marginal excess returns.

Suppose the tracking error is defined as the annualised standard deviation of the monthly excess returns. A portfolio manager can have excess returns of 25 basis points every month. This translates into zero tracking error but positive excess (alpha) returns.

Constructing “enhancers”

A straight-forward approach to constructing an enhanced index is to “tilt” the portfolio. The portfolio manager simply overweights some stocks and underweights certain others to generate alpha.

Another approach is to construct a cashless alpha strategy. This approach combines an index portfolio with a near cashless market-neutral strategy. That is, the portfolio manager will construct an index fund and then go short on certain stocks and use the proceeds to go long on certain other stocks to generate alpha.

Cost of short-selling has to be considered before implementing this strategy.

Alternatively, the portfolio manager can use futures to construct such market neutral strategies.

The third approach is the synthetic enhanced indexing. Here, the portfolio manager will take exposure to the benchmark index through index futures.

This entails paying an initial margin, say, 20 per cent. The portfolio manager will then invest 80 per cent in short-duration fixed-income securities to generate additional returns. This short-duration portfolio will also provide cash if the futures position requires mark-to-market margin.

Mutual funds can only offer portfolio “tilts”, as they are not allowed to use futures for non-hedging purposes. This means that the above-mentioned alternative strategies can be employed only by traders and HNIs.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)