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© Copyright 2000 Rogers Media. The following article first appeared in the July 2001 edition of
BENEFITS CANADA magazine.
VIEWPOINT
Enhancing investments
By Jean Martin Aussant
Enhanced indexing offers the perks of both plain vanilla indexing and active management.
Enhanced indexing--also known as index-plus management--is halfway between plain vanilla indexing and
active management. Enhanced indexing not only aims to replicate the major features of a given bond index,
it also attempts to generate value added.
Proponents of enhanced indexing use active management tools to create capital appreciation. Enhanced
indexing must also ensure that a fund has a minimal level of risk relative to its benchmark. Pension plan
sponsors can look at enhanced index funds as a tool to beat the benchmark index while incurring very
moderate risk.
How much value can be added depends on a number of factors, including the breadth of the benchmark index
and the degree of flexibility in the choice of a sector strategy. The constraints dictated by investment
policy also affect the latitude provided to managers in their search for value added. Risk management takes
on an important role against a background of enhanced indexing.
Market volatility is another major factor. The more interest rates or sector return spreads vary, the more
managers are able to take advantage of these changes and add value by making slight adjustments in relation
to the benchmark index.
Since Canada's major bond index currently contains nearly 1,000 securities, it's a practical impossibility
to hold them all. With pure indexing, a manager seeks to replicate each sector as faithfully as possible.
With enhanced indexing, it's possible to focus on a better-performing asset class to represent an entire
component of the index.
Enhanced indexing takes advantage of regular reinvestments to outperform the benchmark index. Whether in
terms of duration or the weight of sectors and securities within the portfolio, managers maximize the
portfolio's performance while accepting a limited level of risk compared to the index. Using securities
which are outside the index, such as private placements or derivatives, can also be part of an enhanced
indexing strategy.
While enhanced indexing offers some of the benefits of active management and pure indexing in one product,
there are risks involved. Any value added potential also means exposure to a given level of risk. Be it
exposure to changes in interest rates, the allocation of weights to sectors and credit ratings or the
selection of individual securities--all of these factors can clearly produce value added for a fund but
they can also cause it to lag the index if they're not properly managed.
In addition, enhanced index funds may underperform their benchmarks in any given year. In this respect,
only pure index funds can eliminate this possibility. Having said that, however, most pension funds will
attempt to grow their assets over longer periods than a single year.
Jean Martin Aussant is director, quantitative research with Addenda Capital Inc. in Montreal.
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