During the past 30 years, index funds have become one of the most widely used investment vehicles for institutional equity investors. With their ease of use and convenience, it is no wonder that investors have flocked to them. This has lead investors to adopt strategies utilizing index and actively managed funds.

Enhanced index funds lie between the two, taking on a semi-active approach to portfolio management. Enhanced index fund managers appreciate the core theory of index investing, but they believe better returns can be had by using a variety of strategies aimed at outperforming the index, including using derivatives, leverage, strategies to reduce tax, or excluding certain investments based on a set criteria. The idea is to use the index as a base and then make modifications to beat the return of the tracking index.

Be sure to read about How Index Mutual Funds Work.

Enhanced indexing resembles passive management because in theory enhanced index portfolio managers cannot deviate too much from index they are tracking. Further similarities between the two types of mutual funds are low fees, and low turnover. Actively managed funds on the other hand, are free to invest in anything and everything and are not limited to what is in an index. The downsides are higher manager risk, higher fees and turnover, which will ultimately eat into the returns for an investor.

Be sure to also see our Guide to the Turnover Ratio.

Theoretically, enhanced index funds combine the best of both passive and actively managed funds. They offer low operating costs, low turnover, and diversification. Moreover, they implement a variety of enhancement strategies to try and beat the return of the tracking index. Enhanced index funds can be more profitable than regular index funds by:

• Positioning the portfolio to a particular sector
• Timing the market
• Investing only in specific securities in the index
• Avoiding certain securities in the index that are expected to underperform
• Using leverage
• Keeping up to date with market trends

Since enhanced index funds are essentially actively managed, the investment has additional risk in the form of management risk; this is in addition to market risk, whereas index funds only have to worry about market risk. Wrong choices by the manager can hurt future returns. Further, because enhanced index funds are actively managed, they also have higher management expense ratios compared to index mutual funds (but still lower than the average mutual fund).

Be sure to see the Cheapest Mutual Funds for Every Investment Objective.

Enhanced index funds typically have expense ratios between 0.5% and 1% with regular mutual funds having an expense ratio of 1.3% to 1.5%. Again, because enhanced index funds are actively managed, they typically involve higher turnover rates, costing investors in brokerage transaction fees and capital gains. Lastly, they are newer investment instruments and do not have that long of a track record to compare performance. As with any investment, some underperform, others beat their tracking index. It is up to the investor to do the due diligence required looking at the management of the fund, the expenses and turnover to see if they are better off going with an enhanced index fund over a regular index fund.

Take into consideration that because enhanced index funds are actively managed, the turnover in the portfolio will increase the capital gains tax. To avoid capital gains taxes, investors can purchase enhanced index funds through a tax-free account such as an IRA or a 401(k). Look for enhanced index funds with low turnover to limit the tax hit. Also, some enhanced index funds incorporate tax-managed strategies that use capital gains and losses to limit capital gains taxes.

See also our 7 Essential Tax Tips for Mutual Fund investors.

Enhanced Cash

Enhanced cash managers use futures to replicate the index then they take 95% of the capital left after buying futures (which have a 20 to 1 leverage) and purchase fixed income securities.

Trading Enhancements
Short-selling or using leverage to create value through trading.

Exclusion Rules
By using certain filters, some securities are eliminated from the index to improve returns.

Tax-Managed Strategies
Tax-managed index funds manage buys and sells to minimize taxes.

Just as with mutual funds, there are many different kinds of enhanced index funds. Here are some of the top rated according to Morningstar:

Intermediate-Term Bond: T. Rowe Price U.S. Bond Enhanced Index (PBDIX)

• Total Assets: $604M
• MER: 0.30%
• Top Holdings: US Treasury Note 1.75%; US Treasury Note 1%; US Treasury Bond 4.375%; US Treasury Note 2%

Small Blend: Fidelity Small Cap Enhanced Index (FCPEX)

• Total Assets: $384M
• MER: 0.67%
• Top Holdings: Russell 2000, Rite Aid Corp, Acuity Brands Inc., Spirit Airlines, Aspen Technology Inc.

Mid-Cap Blend: Fidelity Mid Cap Enhanced Index (FMEIX)

• Total Assets: $360M
• MER: 0.60%
• Top Holdings: E-mini S&P MidCap 400 Index Future; HCA Holdings Inc.; Cigna Corp; Illumina Inc.; Cardinal Health Inc.

Large-Cap Blend: Steward Large Cap Enhanced Index Indv (SEEKX)

• Total Assets: $214M
• MER: 0.90%
• Top Holdings: Apple Inc; Exxon Mobil Corporation; Berkshire Hathaway Inc Class B; Microsoft Corp; Chevron Corp

Large Value: Fidelity Large Cap Value Enhanced Index (FLVEX)

• Total Assets: $729M
• MER: 0.45%
• Top Holdings: Exxon Mobil Corporation; Johnson & Johnson; General Electric; JPMorgan Chase; Wells Fargo

Foreign Large Blend: Fidelity International Enhanced Index (FIENX)

• Total Assets: $77M
• MER: 0.62%
• Top Holdings: Roche Holding AG; Novartis AG; Nestle SA; BP PLC; Sanofi

Enhanced index funds may not be for everyone, but they can certainly add diversification to an investor’s portfolio. They are convenient and easy to invest in, and can offer higher returns than most other index funds with low fees. Just be sure to do the due diligence required; the additional management risk can either help or hinder an investor’s returns.