Enhanced indexing is a type of investing behavior that combines passive and active investment strategies. Investors who practice enhanced indexing hold diverse portfolios, but they have a focus in their indexing that they think makes their indices better than standard market indices. They may be selective about the stocks they include in their indices or augment common stock holdings with derivatives. Some of these investors have set up funds that hold a portfolio based on an enhanced index and sell shares to other investors.
Traditional indexing is a passive investing approach. It was created by people who studied historical data and found that price prediction was difficult and unreliable. The market as a whole, however, trends upward over time. These researchers formed index funds which held diverse portfolios that attempted to mirror the entire market. The Standard & Poor 500 and the Dow Jones are common stock indices; the corresponding index fund shares derive their value from portfolios that include all of the stocks in their underlying indices in proportions described by the indices.
Stock indices are diverse, but they are not comprehensive. They select a certain group of stocks and do not hold the others; the Standard & Poor 500, for example, gets its name from the 500 stocks in the index. The group of stocks selected by each index gives it a certain individuality. Nasdaq had a reputation as a tech index because it contained a relatively high proportion of technological stocks. In the case of traditional indices, these reputations were based on investors’ perceptions of the indices, and they were not a result of a selective strategy.
Enhanced indexing embraces both the concept of diversification that inspires indexing and the potential for specialization in indices that their individual characters hint at. Investors who practice enhanced indexing consciously try to create high-performing indices, which brings an aspect of active investing to the world of indexing. Any method of creating an index with aspirations of doing better than the market is enhanced indexing.
One way of enhancing a traditional index is to change the stocks that go into it. Fund managers may weed out stocks they feel are too risky because of the characteristics of the company. Often, enhanced indices have minimum standards of measurements like corporate debt to ensure that the stocks that are included in the index have a higher probability of being profitable.
Some fund managers enhance their indices by expanding their portfolios beyond the common stock market. They incorporate options, futures and other derivatives into their portfolios. These practices allow managers to hedge some of the risks they face because they hold common stocks.