The active/passive debate is, of course, a long-running one. Both approaches have their merits. You’re unlikely to outperform the market if you replicate the index. But on the other hand, if you want to avoid underperforming the market, then investing in an index could be a good idea. Especially if you’re looking to minimise costs.
Best of both worlds?
However, we believe active and passive don’t have to be rivals. In fact, they can be combined, potentially offering your clients the best of both worlds.
One option is to mix active and passive strategies in a portfolio. But there’s another way to alloy the attributes of these two contrasting investment approaches into one cost-effective allocation. It’s called enhanced indexation.
Compelling combinations
Enhanced indexation is a systematic equity strategy combining the benefits of both active and passive. An enhanced index strategy has the potential for outperformance at competitive cost. It’s also highly diversified.
The index is our starting point for our investment process. We aim to improve upon it by incorporating various factors that differentiate companies with positive and negative future prospects.
Factors are common themes or attributes that drive risk and return. We think the three factors that are key to future outperformance are:
- Quality
- Momentum
- Value
Quality measures how well companies use their capital. Companies with momentum are essentially those the market likes. Value is a factor that keeps us from overpaying for the combination of quality and momentum. In aggregate, this means we prefer well-managed companies at reasonable valuations preferred by market participants.
It’s hard to predict exactly when quality, momentum or value are going to have a great year. We believe they’ll all perform well over the long run, but each will perform well at different points in the cycle. This means enhanced index investors benefit from diversification of return drivers in addition to diversification across stocks, sectors and regions.
However, assessing companies is just the beginning. We need a disciplined, repeatable process to create a portfolio that continuously benefits from these attributes. We assess the multifactor characteristics of each and every stock in the index.
- We start with the weight of a company in the benchmark and buy more of what we like and less of what we don’t like.
- We want our performance to be driven by Quality, Momentum and Value. So we control for sector risk, stock risk and country risk.
- For the same reason, we also neutralise against dynamic risks and themes (think inflation, elections, wars, and even things like AI – we want to avoid drifting into concentrated positions).
- We monitor the stocks in the index and update our positions as multi-factor scores, risks and themes change.
- We continuously check that our portfolio risks and returns are driven by our preferred factors (quality, value and momentum) and adjust the portfolio if required.
We apply this strategy across 7 regions.
Cost-efficiency
Why are enhanced index strategies becoming increasingly popular with advisers?
A key point about enhanced index strategies is that they’re cost-efficient and therefore potentially represent good value for money. Customers can use them as inexpensive core equity building blocks in multi-asset solutions.
Any remaining fee budget can then be allocated to complementary satellite strategies - everything from small-cap growth to infrastructure to real estate and everything in between.
Conclusion
An enhanced index strategy blends the benefits of cost-effective quantitative rigour with active outperformance potential.
Discover more
To learn more about enhanced indexation, you could visit our quantitative investing webpage, or watch my video on enhanced index strategies. Alternatively, to see how our enhanced index strategies have been performing, you could visit our Fund Centre.
If you’re considering enhanced index strategies for your client portfolios, contact us to learn more about these funds and find out how they can fit into your broader investment strategy.