Passive indexing? Enhanced indexing!

Passive investors simply buy and hold the capitalization-weighted market portfolio at minimal costs. This approach has solid theoretical and empirical foundations. The main claim against active management is that, on aggregate, it is a zero-sum game before costs and a negative-sum game after costs. This would imply that low-cost passive investing should ensure a better performance than the average actively managed fund.

However, there are various arguments to prefer enhanced indexing. First, passive investing focuses solely on the market risk premium, and simply ignores factor premiums for which the literature also finds a lot of evidence. Enhanced indexing does take this evidence into account, as it is designed to benefit from both sources of return. Second, enhanced indexing allows for full ESG integration, whereas passive investors either ignore ESG considerations, or limit their efforts to excluding a handful of the worst offenders. Third, enhanced indexing contributes to maintaining and further improving market efficiency. Finally, we argue that enhanced indexing can be a highly cost-effective solution compared with popular alternative investments, and is more efficient than smart beta approaches, which are designed for transparency and appeal.

“A passive approach ignores factor premiums”

A passive approach ignores factor premiums and just focuses on efficiently capturing the market return. By following an enhanced indexing strategy, investors can efficiently capture the market return and, at the same time, benefit from established factor premiums. This is achieved by taking the capitalization-weighted index as a starting point, and then giving more weight to stocks with favorable factor characteristics and less weight to stocks with unfavorable factor characteristics. With enhanced indexing the individual stock over- and underweights are small and the overall portfolio tracking error is low, i.e. somewhere in the range between 0.5% and 2%. 

The track record of Robeco’s various enhanced indexing strategies shows that the approach does not only work in theory, but also in reality. For instance, our flagship developed markets enhanced indexing fund, which has a tracking error of around 1%, has achieved an outperformance of 1.2% per annum since its inception over 10 years ago, with a positive outperformance in 8 out of 10 calendar years . For emerging markets, our low tracking error strategies have also delivered according to expectations. 

A growing number of institutional investors wish to incorporate Environmental, Social and Governance (ESG) factors in their investment process. Passive investing is not particularly suitable for this, as the whole idea is to not have any view on individual stocks and just buy the entire market portfolio. Large institutional investors can incorporate some ESG considerations by specifying a list of stocks that should be excluded from the index. Such an exclusion policy is usually not regarded as full ESG integration though, because it only focuses on some of the worst offenders and ignores everything else.

“Enhanced indexing allows for ESG integration, without loss of performance”

Enhanced indexing is better equipped for full ESG integration, because once you allow yourself to deviate a bit from the index in order to benefit from factor premiums, you may decide to use some of this room for more thorough ESG integration. For example, in all of our quantitative equity strategies we apply a constraint which ensures that the portfolio ESG score is never below the benchmark ESG score, using proprietary RobecoSAM best-in-class ESG assessments. We find that imposing this constraint has a neutral effect on performance, so it can basically be added ‘for free’. 

Blitz (2014) argues that passive investors are essentially free-riding, and assume that other (active) investors have done their homework properly. For instance, passive investors are not concerned about buying a stock such as Facebook, with a P/E ratio of around 100 after its IPO. They also feel comfortable with buying Greek government bonds, when the benchmark implies that other investors have also done so. Passive investors tend to assume that the price is always right. Paradoxically, however, if everyone were to invest passively, the result would be a complete breakdown of the link between prices and fundamentals. Liquidity would also disappear, as the capitalization-weighted market portfolio reflects a buy-and-hold approach that requires no trading (apart from certain corporate actions, such as IPOs).

So active management is vital to ensure an efficient allocation of capital. Enhanced indexing allows investors to capture the benefits of a passive approach, while being optimized for performance, and at the same time contributes to maintaining and further improving market efficiency.

Enhanced indexing can also be a very cost-effective solution. For this we compare enhanced indexing with two alternative ways of boosting the return of a simple passive equity/bond portfolio, namely an allocation to alternative investments, or the adoption of a smart beta approach.

“It can be a cost-effective solution to boost returns on a passive equity/bond portfolio”

The example below illustrates how enhanced indexing can be more cost-effective than alternative investments.

Consider a pension fund with an allocation of 50% to an LDI matching portfolio (fixed income), 40% listed equities (passive) and 10% alternative investments such as private equity and hedge funds. It is not unreasonable to assume that the fee load involved with the alternatives portfolio amounts to over 2% per annum, i.e. over 0.20% at the portfolio level. This means that a portfolio which simply invests 50% in an enhanced indexing equity strategy is cheaper as long as the enhanced indexing strategy involves a fee of less than 0.40%, which should be quite feasible. Moreover, in order to match an outperformance of 1% per annum for the enhanced indexing strategy, the alternatives portfolio should outperform the market index by 5% per annum (after costs!), which does not sound like a reasonable expectation. Enhanced indexing seems to offer a better cost/benefit trade-off.

Enhanced indexing is designed to exploit established factor premiums, but so are smart beta indices. Smart beta offers full transparency and fee levels that are probably even lower than for enhanced indexing. Still, the case for enhanced indexing may be stronger. For one, enhanced indexing is optimized for performance, while smart beta indices are designed with simplicity and transparency in mind. Not constrained by this, enhanced indexing can make use of more advanced variables and more sophisticated portfolio construction and risk management techniques. In addition, enhanced indexing offers a stable tracking error, while the tracking error of smart beta indices can vary a lot over time. 

Investing in a purely passive manner is increasingly popular. Although we do not deny that this has its merits, enhanced indexing may be an even better alternative. Unlike passive investing, it is designed to benefit from factor premiums, allows for full ESG integration, and contributes to market efficiency. Compared with popular alternative investments it is highly cost-effective, and it is more efficient than smart beta approaches.