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Enhanced Indexing

IN RECENT YEARS, Wall Street has been abuzz with terms like smart beta, factor investing and fundamental indexing. What’s this all about? Think about the money-management business from Wall Street’s perspective.

Actively managing portfolios is lucrative for financial firms. But many investors have wised up to their poor performance, prompting them to buy index funds instead. Problem is, index funds aren’t nearly as profitable for Wall Street. What to do? Wall Street’s answer: Find a way to make more money off indexing by offering index-like funds that hold out the promise of market-beating returns.

Welcome to the world of enhanced indexing, where the goal is to capture the performance of those parts of the market that tend to outperform. Enhanced indexing has two strands.

The first strand focuses on factor investing, which involves overweighting stocks with certain attributes. Academics have long contended that, if you want higher returns, you need to take greater risk. That greater risk comes partly from favoring stocks over more conservative investments. But even within the stock market, academic research suggests you can enhance returns by taking the risk of overweighting at least four types of stocks: smaller companies, value stocks, those displaying price momentum and those with greater gross profitability.

The second strand involves a push to adopt alternative systems for weighting the stocks held within an index fund. Known as fundamental indexing, the idea is to own companies based on their economic importance, rather than their value as judged by the market. That economic importance is assessed using measures such as a company’s total earnings, dividends or sales.

You can now buy mutual funds and exchange-traded index funds that seek to take advantage of factor investing and fundamental indexing. ETFs, in particular, have been launched thick and fast, as Wall Street firms vie to get their slice of the market for enhanced indexing.

Our Humble Opinion: We favor tilting a portfolio toward value stocks and small-company shares. But we aren’t entirely convinced that these two sectors will continue to outperform, which is why we also recommend a core position in funds that give exposure to the broad stock market, both in the U.S. and overseas.

Next: Small-Stock Effect

Previous: High Risk, High Returns?

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