Indexes add strain
NEW YORK – Wall Street is at times so competitive that even the C-students can be hard to beat.
When the merely average – such as benchmarks like the Standard & Poor’s 500 index and the Dow Jones industrials – perform as well as they have recently, mutual funds that try to mimic but stay ahead of a major market indicator can be hard pressed to make a case for themselves.
So-called enhanced index funds try to do it by largely mirroring the investments of a particular index and then attempting to wring further gains by also making side investments, for example, in stocks outside the index. Managers of enhanced index funds need to make smart calls if their funds are to appear attractive when compared with regular index funds, which generally offer lower fees and greater tax efficiency.
Lately, major market indexes and the funds that track them have given investors reason to pay attention. On May 30, the Standard & Poor’s 500 index broke a seven-year-old closing record, signaling the index of large U.S. companies had fully recovered from the dot-com flameout.
The resurgent S&P joins indicators such as the Russell 2000 index of smaller companies and the Dow industrials, which have for months been setting record closes in quick succession. Many regular index funds are tied to the performance of these indexes, meaning many investors are seeing their gains push higher.
Joel Dickson, a principal at Vanguard Quantitative Equity Group, noted that many enhanced index funds, when looking for side investments, will turn to companies that are smaller than those of the rest of the fund. So a fund tracking the S&P 500 might invest in what is still a large company but is simply smaller than most of those in that index. Their comparatively smaller size can bring opportunity for gains, he noted.
“One of the reasons that these types of strategies have become so popular in recent years is because they’ve performed well,” he said.
Observers note that the frequent trading that enhanced index funds often rely on to stay ahead of an index can trigger greater capital gains taxes than regular index funds typically do. Experts recommend those investing in enhanced index funds consider keeping them in tax-deferred accounts such as 401(k) plans.
And although the enhanced index funds rely on managers to help tweak their investments and boost returns, fees shouldn’t be outsize, experts say.
“Their whole strategy is based on trying to edge out the benchmark over time. And a key factor in that success is they need to have low expenses to help them achieve that goal,” said Sonya Morris, an analyst at investment research provider Morningstar Inc.
Omar Aguilar, head of quantitative equity trading at ING Investment Management, said enhanced index funds can face difficulty because they must try to add juice to their returns without straying too far from the index on which they are based. Generally, he noted, the fund shouldn’t stray from the index by more than 2 percent.