Pushing Index Funds A Bit Higher

Funds start with indexing and then tweak here and there to help goose returns.

Valued for their simplicity and rock-bottom expenses, index funds have won a place in millions of investors' portfolios. But the idea of matching rather than beating the Standard & Poor's 500-stock index is hard to take for the ever-optimistic sorts. That's why companies are creating mutual funds that hew to the index idea -- a stable set of stocks and low costs -- and adding financial engineering, making measured bets hoping to earn higher returns. Such ``enhanced'' index strategies have been gaining favor with institutional investors for years and now account for 10% of their equity assets. Among individual investors they amount to roughly 1% of equity fund assets. But some industry watchers expect a growth spurt, especially if the market remains stuck in a narrow trading range. These portfolios may also appeal to investors who are growing tired of underachieving actively managed funds but don't want to settle for the returns of an index fund.

There are many ways to boost index returns. Some funds use a combination of stock-index futures and bonds. Others target specific stocks that are in an index, overweighting those they think are especially undervalued and underweighting those thought to be too dear. Then there are those that create their own indexes they hope will be better performers than older ones, such as the Standard & Poor's 500-stock index.

The extra attention comes with added cost. While the expense ratio on plain-vanilla index funds averages 0.45%, most enhanced funds hover around 0.90%. While that's still lower than the average of 1.30% for actively managed funds, it's nonetheless a drag on performance. ``You can be as enhanced as you want to be, but if you have a truckload of expenses, the enhancement isn't going to amount to much,'' says Morningstar's director of fund analysis, Kunal Kapoor.

Tax-wise, enhanced funds -- particularly ones that use futures and bonds -- can generate more capital gains and taxable income than simple indexers do. That makes them a better choice for tax-sheltered accounts such as 401(k)s or IRAs. Of course the biggest knock comes from pure indexers who argue that it's just another form of active management.

The simplest method of enhanced indexing -- and the one generally considered the least risky -- involves derivatives. Funds such as Payden Market Return (PYMRX ), Pimco StocksPLUS (PSPAX ), Pimco StocksPLUS Total Return (PTOAX ), and Metropolitan West AlphaTrak 500 (MWATX ) buy S&P 500 futures to match the performance of that index. That leaves managers with a big pile of cash since they need to put down only about 5% to secure the futures. The rest is invested in debt securities. In general, as long as the bonds earn more than a money market rate -- plus expenses -- the funds can best the index.

Payden, Pimco, and Metropolitan West are all bond specialists. They seek to add extra return through the management of fixed-income holdings. While many of these funds buy short-term bonds, the souped-up Pimco StocksPLUS Total Return takes more risk. The fund's fixed-income portfolio, managed by bond king William Gross, invests across the yield spectrum. Pimco StocksPLUS sticks with short-term bonds. Since 2002, Pimco StocksPLUS Total Return has gained 12.2% a year, vs. 8.3% for StocksPLUS and 8.2% for the S&P 500.

Another common tactic for ramping up returns is to overweight or underweight stocks of specific companies. Funds that do this generally rely on quantitative models that analyze price-to-earnings ratios, earnings growth, and other common metrics. For example, Vanguard Growth & Income (VQNPX ) -- which has beaten the S&P 500 index by half a percentage point a year for the past decade -- has 5.2% of its assets in Exxon Mobil (XOM ). The energy giant makes up just 3.5% of the S&P 500. The fund keeps both its sector and industry weightings within 1% of the index, a measure to temper risk. Laudus Rosenberg U.S. Large Capitalization Fund (AXLVX ) follows a similar strategy. But it aims to trump the Russell 1000 Index, which it has done by one percentage point a year since its inception in 2002.

Other funds go a step further, creating all-new benchmarks. Pimco Fundamental IndexPLUS and Pimco Fundamental IndexPLUS Total Return, launched in late June, use a customized index of the largest 1,000 stocks. But rather than using market cap as the measure for ranking stocks, the fund chooses shares according to a formula that takes into account revenue, earnings, book value, and dividends. The list will be recalculated annually, and the funds will use inflows to keep in balance.

Why come up with this new index? ``The classic indexes overweight the overvalued stocks and underweight the undervalued stocks,'' says Robert Arnott, chairman of Research Affiliates, who created the customized index used by the two Pimco funds. Arnott says his research shows that his index has outperformed traditional cap-weighted indexes by two percentage points a year over 40 years. These two Pimco funds will use equity swaps -- essentially customized derivatives purchased from an investment bank -- instead of stocks to match the performance of the index. That frees up additional money to invest in bonds.

Such strategies come with no guarantee that they'll beat the S&P 500 index. Skeptics argue that these offerings are still actively managed since they depend on the discretion of stock or bond managers to build a winning portfolio. Yet for investors frustrated by the high cost of typical actively managed funds and the low-return market environment, a juiced-up index fund may provide a timely balance.

By Adrienne Carter

Before it's here, it's on the Bloomberg Terminal. LEARN MORE