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In Between Active and Passive

Using quantitative methods, enhanced-index strategies add an active component to passive investing.

Michael Rawson, 02/15/2011

This article first appeared in the February/March 2011 issue of Morningstar Advisor magazine. Get your free subscription here. 

Exchange-traded funds have become popular tools for establishing the passive building blocks of a portfolio because of their low costs and tight tracking errors. One area in which they have yet to move the needle is in active management. And it's not without reason. What successful mutual-fund manager wants to disclose his or her holdings every day, as ETFs are required to do? Transparency is fine when you have 500 holdings and no fundamental opinion about them. But when you are an active manager with 30 to 40 ideas, you don't want to disclose to the market that you are buying or selling a stock.

Somewhere in the middle of the active/passive spectrum lies "enhanced" indexing. This approach relies on quantitative or rules-based methods, usually in the form of slight factor tilts to a traditional index. The result is a portfolio with characteristics that active managers usually seek, such as stocks with low price/earnings ratios or good momentum, and the mechanical and predictable attributes that indexers like. Enhanced-index fund managers usually do not mind disclosing their holdings, because their active bets are so small that the decision to sell one stock should not influence its price.

ETFs that use enhanced-indexing strategies are showing signs of success (Exhibit 1). A number of them have achieved 4 or 5-star Morningstar Ratings. And while all enhanced-index ETFs rely on quantitative methods, they vary in their degree of complexity, ranging from a simple equal-weighted and dividend-yield approaches to more-complicated multifactor strategies.

(View the related graphic here.)

Changing Weightings
Perhaps the least complicated enhanced-index fund is Rydex S&P Equal Weight RSP. It follows an equal-weighting methodology, holding the exact same securities as the S&P 500, but weighting them all the same. Where the top 10 securities make up 19% of the cap-weighted S&P 500, those same stocks make up just 2% of the Rydex fund.

The result is a portfolio with a return profile more like a mid-cap fund, with the resulting higher volatility. The S&P has more than half of its assets tucked in to giant caps and less than 12% in mid-caps; it's roughly the opposite in the Rydex fund, meaning that the fund is much more responsive to factors such as momentum and valuation. (Mega-cap companies tend to grow much more slowly and are less responsive than smaller companies to these factors.)

This equal-weighting approach worked great during the past 10 years, but will it work during the next 10? Small-cap stocks now trade at a valuation premium to large caps, while the opposite was true a decade ago. Large caps also have more international revenue and will be more resilient in the face of anemic economic growth. But even if small caps do not do as well, the strategy also benefits from a forced rebalancing to maintain the portfolio's equal weightings. Every quarter, the fund buys the stocks that have sold off and sells the ones that have appreciated--it is buying low and selling high.

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