Enhanced Indexing: Understanding The Challenges And Opportunities

|
Includes: AAPL, AMZN, BND, FB, GOOG, GOOGL, KO, MECIX, MPAIX, NFLX, PG, VTI
by: Craig Blanchfield, CFA
Summary

Enhanced indexing is a portfolio management approach that attempts to increase returns by building a portfolio around core, index-like positions.

Actively managed mutual funds are unlikely to add sufficient risk-adjusted returns to make enhanced indexing a worthwhile exercise.

Choosing individual stocks can prove successful within an enhanced indexing strategy, but the results are extremely sensitive to the performance of the specific names chosen.

(Photo Source)

Enhanced indexing has been used by professional portfolio managers for decades. The approach calls for investing the majority of client assets in core holdings that hug an index, essentially providing a low tracking error core to the portfolio. From there, the manager will make tactical tilts toward specific sectors, styles, or individual stocks. The rationale is that by holding most of the assets in an index fund and adding these tilts, the client’s portfolio will benefit from improved risk-adjusted returns. Furthermore, while tracking error will increase, it is typically maintained at a level aligned with client preferences. While this all sounds attractive, it is more difficult to realize than what many might believe at first glance. That being said, it has been done, but like most active management strategies, it is difficult to determine if the benefits are a result of luck or skill.

Enhanced Equities

Implementing an enhanced indexing strategy within your equity allocation can be done in several ways and at a low cost. To accomplish this, investors first need to decide if they want to combine their current passive holdings with professionally managed active strategies or if they would prefer to construct a portfolio of individual names on their own.

For example, investors using the Vanguard Total Stock Market ETF (VTI) have a core, low-cost, passively managed exposure to U.S. stocks, with a meaningful tilt toward large cap. With an expense ratio of 0.04% and over 3,600 holdings, it is the definition of low-cost and diversified. To enhance this indexing approach, an investor could add a small position to an active large-cap growth or value manager, or both. The same could be done at the mid-cap and small-cap levels as well.

For example, let’s look at an investor with an 80/20 allocation consisting of two funds: 80% VTI and 20% in the Vanguard Total Bond Market ETF (BND). Now let’s assume that the investor wants to keep 90% of the portfolio, the core holdings, within the low-cost passive strategies. For the equity allocation, this means keeping 72% of portfolio value in VTI. The additional 8% in equities provides the capital to allocate to active positions.

For the sake of illustration, let’s say that this 8% is divided 4% each into an active large-cap growth manager and a small-cap growth manager. The end result could look something like the following: 72% of VTI, 4% of Morgan Stanley Institutional Fund, Inc. Advantage Portfolio (MPAIX), and 4% of AMG Managers Cadence Emerging Companies Fund (MECIX). The Morgan Stanley fund has a high minimum investment due to the institutional share class, is concentrated in only about 30-35 positions, and has an expense ratio of 0.85%, which is above average, according to Morningstar. The AMG Managers fund is not quite as concentrated with nearly 100 positions, and is moderately expensive at 0.98%.

To find these funds, I used a screen in YCharts that included the following requirements: U.S. equity only, large and small growth managers, a history of at least 10 years, and an expense ratio below 1.0%. I then sorted by performance and Sharpe Ratio. Then, I scored the results by weighting all-time total returns and Sharpe Ratio, and chose the funds with the highest scores for this illustration. Of course, by doing this, I am benefiting from hindsight, which reinforces the point that enhanced indexing is more difficult than it appears.

The chart below shows that the enhanced index equity allocation outperforms a portfolio holding only VTI. It does so by less than 10% over 10 years, however, and with the benefit of cherry-picking which funds to use. While the total return over this period is greater, it would be difficult to duplicate without the benefit of hindsight. I have also used growth managers, as growth has materially outperformed value for several years now. With these advantages, one would expect the enhanced portfolio to substantially outperform the completely passive, low-cost index fund. I tried, but couldn’t make it work well enough to tout the benefits of enhanced indexing using actively managed funds. The results from including active value managers were even more underwhelming. In either case, the goal of improving long-term total returns on a risk-adjusted basis is difficult to achieve in this manner.

Considerations for Fixed Income

Like equities, the fixed-income allocation can be enhanced through the addition of niche or alternative strategies that are actively managed. However, the impact of doing this is likely to be even more muted compared to that within equities. In other words, while adding high yield or other alternative strategies to the fixed-income allocation may increase expected total returns, these higher returns are likely to be accompanied by a commensurate amount of risk. For most investors, the drivers of long-term returns are within the equity allocation. And for this reason, I have chosen to make that the focus of this article.

The chart below shows the combined enhanced portfolio of both equities and bonds compared to the passive portfolio of 80% VTI and 20% in BND. As expected, the difference in return is less than 10% over the past 10 years.

Better Luck with Stock Picking?

Maybe.

Much like adding active strategies managed by professional money managers, investors can carve out portions of their portfolio to add to individual names to attempt to accomplish much of the same objectives. That is, by choosing both slow and steady as well as secular growth stocks, long-term investors can potentially add incremental returns to their portfolios that can compound to meaningful outperformance over time relative to a strictly passive approach.

The caveat is that while this approach will increase tracking error relative to appropriate benchmarks, it is not guaranteed to necessarily create outperformance. By adding individual names using this strategy, investors are also adding idiosyncratic risks. For this reason, allocations to individual names should be limited to a level that would be palatable in the event the stock goes to $0.

To show how adding individual names can add value, let’s look at an extreme example. Let’s take the same 80/20 portfolio and carve out 10% of the equity allocation to invest in the FAANG stocks. Like above, this example maintains 90% of the equity allocation in VTI and the remaining 10% spread evenly across Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NFLX), and Alphabet (GOOGL). Facebook didn’t go public until 2012, so for this example, I started the performance analysis then. One question, and challenge, of this approach and analysis is as follows: With the volatility of the individual names, how likely is it that the average investor, even after making these picks, would have held tight for the past 7-10 years?

While this is meaningful outperformance, 28.9% more money as a result ((202.7%-157.2%)/157.2%)), it would have only been achieved by investing in these high-flying names and holding on through the ups and downs.

These results are unsurprisingly muted by substituting slow and steady names for the two best performers within FAANG. For example, if we substitute Coca-Cola (KO) and Proctor & Gamble (PG) for Amazon and Netflix, the two best performers over the same period, the results are significantly different.

Key Takeaways

There are several takeaways from this analysis. First, even with the benefit of hindsight, it is not a trivial task to consistently outperform a completely passive, low-cost, low-turnover, and broadly diversified portfolio. Second, using concentrated actively managed funds is unlikely to add enough to risk-adjusted returns to be worth the trouble. They simply do not generate the level of returns required to make a meaningful difference across a diversified portfolio. Third, choosing individual equities can provide the desired results from enhanced indexing strategies, but this comes with some important considerations. Choosing individual stocks exposes investor portfolios to idiosyncratic risks for which investors are not always compensated. It is also difficult to choose the big winners in real-time, also known as real life. The results of this strategy are extremely sensitive to the differences between choosing the big winners from the losers or even just the moderate winners. Finally, most investors are emotional humans that react to headlines, earnings reports, rumors, etc. For example, with the volatility in Netflix, how many investors held on to their entire position for the past 7 years to realize the nearly 2,300% appreciation over that period? I’m guessing not many. While it's great for those who did, the actual investment outcome for individual investors has likely been very different.

Final Thoughts

The ideas I described above can be interpreted as being tactical given the suggestions to add to specific areas or stocks. Using the above strategies should be looked at within the broader context of the global financial markets and sized appropriately. These suggestions are intended to be incremental moves that tilt the complexion of portfolio assets in a way that may improve investment outcomes. Any overweight or underweight position to an asset class, sector, equity style, or individual stock needs to be considered carefully to understand its impact on long-term total returns. I look forward to your feedback and answering your questions in the comment section below.

Disclosure: I am/we are long FB, AAPL, AMZN, NFLX, GOOGL, KO, PG, VTI, BND. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Mosaic Advisors ("Mosaic"), including the author, or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level, be suitable for your portfolio or individual situation or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Mosaic or the author. Mosaic is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the Mosaic's current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.