Active management is exciting but risky because active bets can lead to underperformance. Passive management, on the other hand, is unexciting and at best only mirrors the benchmark returns. Choosing between the two is not always easy. Fortunately, investors have a third choice called enhanced indexing.

This article explains the concept of enhanced indexing. It then shows how discerning investors can create similar portfolio using index funds.

Passive management refers to managing a portfolio that generates the same return as the benchmark index. Index funds follow passive management. An active portfolio manager, on the other hand, has a mandate to deviate from the benchmark index to generate excess returns or alpha.

The problem with active management is that alpha is a zero-sum game. That is, some active managers will outperform benchmark return and some will underperform benchmark. The total of all positive and negative excess returns will be zero because the successful active managers will earn their excess return from the ones that underperform.

This makes the manager selection process important; for selecting the wrong manager would lead to portfolio underperformance.

Enhanced indexing is a process that allows portfolio managers to marginally deviate from the benchmark. An enhanced indexed fund, for instance, could have a mandated tracking error of 2 per cent. This means that the annualized standard deviation of the difference in monthly returns between the portfolio and the benchmark should be managed within 2 per cent every year; this controls the portfolio's active risk. Additionally, these managers may be given a mandate to generate alpha, say, one per cent. This automatically translates into a mandate to generate an information ratio (ratio of alpha to tracking error) of 0.50.

Enhanced indexing is popular among investors that do not want exposure to high active risk. Professional money managers typically use quantitative models to deviate from the benchmark index and stay within given investment mandates.

Suppose a portfolio manager believes that HDFC Bank is likely to outperform the Nifty Index.

The portfolio manager may want a 7.5 per cent allocation to the stock against its 5 per cent weight in the index. This excess allocation to the stock has to come from other stock(s) that will be underweighted against the index. The portfolio manager has to simultaneously ensure that she stays within her mandated tracking error.

Individual investors may not have the resources to apply such models. Such investors should buy an index fund and adjust their holdings using stocks and single-stock futures. This is based on the rationale that an enhanced index portfolio is nothing but an index fund with some stocks having marginally different weights compared with the benchmark index.

But even such a process could be tedious to implement. If the individual investor believes that Reliance Industries is likely to underperform the benchmark index, she has to underweight the stock in her portfolio. This means she needs to short Reliance Industries, as the index fund already holds the stock in same weight as the benchmark index. And not all investors fancy short-selling. It is, therefore, optimal for investors to only buy stocks that they believe are likely to outperform the index.

Investors should not take more than three active positions at any given time to ensure deviations from the index are small and manageable. Further, such active positions should not constitute more than 10 per cent of the index portfolio value.

Downside risk should be controlled using stop loss or other risk management measures.

Enhanced indexing carries minor tilts to an index fund and offers risk-controlled alpha returns. Investors can create similar portfolio using index fund and individual stocks and single-stock futures. Enhanced indexing is optimal for creating target portfolio to meet specific investment objectives.

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