Index Funds: Enhanced? Only The Expenses

Funds that try to beat the index mostly get beaten

Equity index funds have been so hot that the idea of an "enhanced index" fund designed to beat the Standard & Poor's 500-stock index by a percentage point or two should be even hotter. Although 50 enhanced S&P funds now beckon to investors, however, they don't always live up to their billing. "Many aren't particularly index-like, nor do they always provide much enhancement," says Mark Riepe, head of the Schwab Center for Investment Research at Charles Schwab.

Indeed, only 12 out of the 21 funds that have been around for three years through June 18 have beaten the S&P. One reason for the underperformance: Enhanced funds suffer from high expenses and portfolio turnover--just what index funds are supposed to avoid. Yanni-Bilkey Investment Consulting in Pittsburgh figures that the expense ratio for the average enhanced index fund is 1.1% of assets. While that's less than the 1.47% ratio for the average actively managed fund, it still is more than double the spartan 0.54% for conventional index funds. What's more, the average enhanced index fund turns over about 97% of its portfolio each year. Such high turnover can cost shareholders because any short-term capital gains from the trades are taxed at ordinary rates. Smith Breeden U.S. Equity Market Plus, for example, had a capital-gains distribution of $1.91 per share in 1998. Conventional index funds, of course, have minimal portfolio turnover.

Enhanced index-fund managers try to beat their benchmark several ways. One is by using leverage. Some funds buy and sell stock-index futures contracts and options along with equities--or even in place of them--in an attempt to earn 50% to 200% of index returns. Rydex Nova, for example, tries to beat the S&P by 50%. It hasn't accomplished that since its inception in 1993, but it did return 27%--nearly four percentage points more than the index--over the 12 months ended on June 18. Of course, leverage can cut both ways. When the market is falling, Rydex Nova declines by a greater amount than the S&P. Last year, when the S&P market fell 18% between July 17 and August 31, Rydex Nova fell 27%.

A SAFER WAY. Other enhanced index funds try to improve performance through superior stockpicking. For example, John Nagorniak, manager of Vanguard Growth & Income, owns about 140 of the 500 stocks in the S&P. The 10 largest stocks in the S&P make up 21% of the index, but Nagorniak holds only four of those stocks in his top 10, which makes up 27% of his portfolio. At 3.96% of the fund's assets, his biggest holding is Tyco, a diversified manufacturing company that makes alarm systems, among other items. Tyco is not in the S&P 500 top 10. Nagorniak's fund returned 28.38%, vs. 26.90% for the S&P for the three years ended on June 18.

A third way that managers try to enhance the index is to buy S&P futures contracts and invest most of their fund's cash in short-term bonds. Both Smith Breeden U.S. Equity Market Plus and Payden & Rygel Market Return follow this strategy. "If you buy the wrong stock, you underperform the index by a huge amount," but not so when you buy the wrong bond, says John Sprow, manager of the Smith Breeden fund.

Since the fund's inception in 1992, Sprow has returned 22% annually, compared with 21% for the S&P. To achieve his returns, he looks for mispriced bonds. Last year, 50% of Sprow's fund was invested in adjustable-rate mortgage debt because he thought it was underpriced. He sold off most of the holding this year as ARMs rose in price.

The S&P 500 isn't the only index to beat. ProFunds UltraOTC, which tries to beat the technology-heavy NASDAQ 100 index by two times, has had a great run. By relying heavily on options and futures trading, UltraOTC returned 146.6% for the 12 months ended June 18, vs. 78% for the index. But this fund is a notable exception. Considering the few extra percentage points of return that most enhanced index funds may give you, you're better off sticking with a conventional index fund. That's where you'll find lower risk and expenses, plus minimal tax liabilities. Over the long haul, those features can add plenty to your investment returns.