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B. Venkatesh

THE stock market has moved up considerably in the last two months. In such a market, active funds outperform index funds. However, when the market is down, index funds typically tend to be better performers.

Some portfolio managers, therefore, follow an investment strategy that betters the index funds when the market is up, but does not perform as poorly if the market is down. This investment strategy is called enhanced indexing. What is this strategy?

In pure indexing, the funds invest only in the stocks that constitute the index, and in the same proportion as that in the index. For instance, if Hindustan Lever constitutes 14 per cent of the Nifty, an index fund with assets of Rs 100 crore will invest Rs 14 crore in this stock.

An active fund invests in stocks based on some valuation criteria. A fund following value-style, for instance, may pick stocks that have high dividend yield. Importantly, active funds do not restrict themselves to the stocks that constitute the Nifty and Sensex.

An enhanced index fund invests only in index stocks, but manages the portfolio actively! That is, the portfolio manager does not strictly invest in the same proportion as that in the index. The manager will instead invest more in the stocks that he considers undervalued, less in the overvalued stocks and in the same weight in stocks that are fairly priced.

This results in higher tracking error — the standard deviation of the difference in monthly returns between the fund and the index.

The enhanced indexer, therefore, adopts measures to contain tracking error. Suppose there are three stocks from the textile industry with 10 per cent weight in the index. The fund may overweight one stock, and underweight the other two, but keep its exposure in the textile industry to 10 per cent.

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