In the 1970s, firms like Vanguard began offeringpassively managed index funds to US investors.Unlike actively managed funds, index funds don'ttry to beat the stock market. Instead, they mimic theentire market or certain market segments with lowoperating expenses, low turnover, and diversification.Studies show that indexing approaches outperformmany actively managed approaches over thelong term. Consequently, investors already have trillionsof dollars invested through traditional passive/indexing investment strategies.
While the number of index funds has exploded inthe past 15 years, most traditional index funds usethe same basic approach they used more than 30years ago. But recent innovations now enable sophisticatedinvestors and advisors to use enhanced indexfund strategies that offer compelling advantages overtraditional index funds. Since traditional indexing isalready superior to many other approaches, enhancedindexing is a powerful option. Properly used,it could meaningfully enhance your current portfolio.Unfortunately, most investors have never heard ofenhanced indexing.
Like traditional index funds, enhanced index fundsoffer the same advantages of low operating costs, lowturnover, and diversification. In addition, they utilize avariety of enhancement strategies. Some of the morecommon enhancement strategies include the following:
•Index construction enhancements. Insteadof relying on external indexes created by third partieslike S&P or Dow Jones, enhanced indexes often useproprietary indexes. Alternatively, they use dynamicrather than static indexes.
•Exclusion rules. By using additional filters,some enhanced indexes eliminate securities likely toreduce performance that would be otherwise includedin traditional indexes (eg, companies with excessivedebt or those in bankruptcy).
•Trading enhancements. Utilizing intelligenttrading algorithms, some enhanced index funds createvalue through trading (eg, by buying illiquid positionsat a discount or by selling more patiently thantraditional index funds).
•Portfolio construction enhancements. Enhancedindex funds sometimes implement holdranges that reduce portfolio turnover by allowingfunds to hold positions during buffer periods evenafter traditional sell signals are triggered.
•Tax-managed strategies. Among the newestenhancements, tax-managed index funds managebuys and sells to minimize taxes. These tax-managedindex funds can be superior to variable annuities fortax-efficient wealth creation.
The better enhanced indexing strategies have outperformedtheir traditional index counterparts by1% to 3% per year or more. With compounding, thisdifference really adds up. Physicians with retirementplan assets are particularly good candidates to considerenhanced indexing. Certain enhanced indexfunds are available to the public through exchange-tradedfunds, while others, like the outstanding noloadlow-cost enhanced index funds offered byDimensional Fund Advisors, are available onlythrough a select group of fee-only advisors. You canuse enhanced indexing either on a stand-alone basisor in an institutional-style core/satellite portfolio thatalso includes actively managed strategies.
Whether you implement it on your own or with thehelp of a skilled advisor, enhanced indexing can makea major contribution to your financial freedom.
Kaushal B. Majmudar, CFA, is president of the Ridgewood Group,a Short Hills, NJ-based money management firm focusing onintelligent investing that is rated 5-Stars, their highest rating, bythe Paladin Registry. Founded by Mr. Majmudar and Ms. AhalyaNava, a Harvard Business School graduate, the Ridgewood Grouphelps clients around the country manage their wealth more intelligently. Theywelcome questions or comments at 973-544-6970 or firstname.lastname@example.org.For more information, visit www.ridgewoodgrp.com.