They take the capitalization-weighted index as a starting point. Then they give slightly more weight to stocks with favorable factor characteristics and slightly less weight to stocks with unfavorable factor characteristics, using proprietary investment models. This enables both relative cost effectiveness and prevents overcrowding and arbitrage. The key performance indicator for this kind of product is the information ratio, which measures the excess returns of a portfolio relative to its benchmark.
Enhanced indexing portfolios typically deliver moderate outperformance, or at least market-like returns after costs, depending on how much portfolios are allowed to deviate from their benchmark. Portfolios with greater tracking error flexibility are more suitable for investors who aim to capture more of the factor premiums in a consistent way. Our research shows that the looser the tracking error criteria, the higher the expected returns tend to be.
Enhanced indexing also enables comprehensive ESG integration. For example, ranking methodologies based on sustainability scores can be introduced in the portfolio construction process. Meanwhile, passive investors either completely ignore ESG considerations or limit their efforts to rigid exclusion lists.