Wednesday, May 16, 2007
The Enhanced fund
Enhanced index funds are just that, your typical index fund such as an S&P model that is then reallocated to provide the best risk to reward ratio possible.
The Index fund is relatively new in the history of the marketplace. In 1975 the first index fund sprung from the earth led by John Bogle; better known for his involvement with Vanguard funds as Vanguard now has a large portion of the world’s assets. Indices are regarded as some of the best ways to enter the market with minimal returns and decent risk factors.
Index Funds are quite simple in that they are built to model after a particular index. The fund is dispersed just as the index is and performs all the same. Through minimal trading and the ability to contain a large amount of investor funds, these have become a staple at mutual fund companies.
Index funds are meant to track the market as a whole. Moving on pace with the market is the best way to curb inflation but still save enough for all of life’s large expenses.
Index funds, because of their low turnover rates, require less work to keep open. Ultimately this low overhead leads to lower fees charged on the fund, and higher returns. Because the fund is not flipped over that often, the management plays little role in its performance. Also, limited volume keeps the fund in check. A fund manager cannot so readily move the assets around.
The enhanced index fund wishes to change all this. Essentially, a fund manager will modify the portfolio to include stocks of the index, but reallocate the investment dollars so the fund achieves the best return possible. These funds also speak of lowered risk, but a measurement for this figure is hardly exact.
See, the S&P money is distributed by market cap. The largest 20 of the S&P companies account for over one third of the value of the entire index. As you can see, money in these index funds is often heavily shifted to the largest corporations which cannot sustain the strong growth rates of smaller businesses. Index funds are rather straightforward and easy to understand from the perspective of any investor as he or she knows exactly what is being bought and sold in the fund. This takes a lot of strain off the fund’s call centers when the fund/market has a bad year.
In the year 2000 when the market experienced its most recent crash, the average index fund got crushed. As you can see, the index fund is weighted by market cap. Those stocks that had moved up 500% plus the year before were now the most heavily purchased stocks in the index funds. A mix for disaster you might argue. As with all market rebirths, the smallest of companies are often the quickest to show improvement. This just happens to be a double edge sword for index funds.
One thing, as an investor, that we do not want from an enhanced fund is more active management. In my opinion, it is more important to me that the mutual fund has lower turnover rather than an active index fund. An active index fund is oxymoronic as indices are built for longer time periods. Too be quite simple, with an enhanced index fund, the operator prefers to have the core strategy of an index then modify the capital allocation in order to provide the best returns. Even simpler is the manager takes money from the largest of corporations and places it in the smaller corporations.