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HomeInsights and ResearchEnhanced indexing: combining alpha with diversification
Over the last 15 years, a tidal wave of cheap money has blurred the lines between high- and low-quality assets. However, a combination of higher interest rates and tighter monetary policy has changed this. Costly debt, along with an uncertain economic backdrop, is forcing investors to be more discerning. Fundamental metrics that underpin company valuations and quality assessment, which are the grounding behind good investment practice, are starting to be rewarded. This creates an attractive environment for an enhanced index approach.

Enhanced indexing – what are we talking about?

Enhanced indexing is an investment strategy that aims to generate above-benchmark returns within a controlled risk budget. It uses data analysis and statistics to systematically build portfolios and gain exposure to specific risk premia (factors). By identifying and targeting specific characteristics, or factors, that have historically been key drivers of a stock’s price over the long-term, each strategy is designed to outperform its applicable market index.

Among the most well-recognised risk premia factors are:

  • Quality – companies with strong financial health and stable earnings.
  • Value – undervalued companies trading below their intrinsic value.
  • Momentum – companies with strong recent performance, which are expected to perform in the short-to-medium term.

The stocks held in enhanced-index portfolios are selected from broad market indices and the weights of the stocks are driven by the size of their exposure to the risk premia. They also maintain index constraints, such as stock, country or sector exposure. This rules-based methodology aims to harness extra returns that are generated through factor exposure, while maintaining a low tracking error to the benchmark.

How each factor is defined, and the subtle mix of factor exposures, will determine whether an enhanced-index manager is successful.

Why now for enhanced indexing?

Enhanced indexing can take various forms. We believe a multi-factor approach that takes account of value, quality and momentum is most appealing to investors – particularly in current market conditions. Here’s why:

  • A mathematical argument for valuation
    Company valuations rely on discounted cashflows models. Higher interest rates mean higher discount rates. A higher discount rate disproportionately affects the valuation of stocks that rely on cashflows far into the future (i.e. growth stocks). This makes stocks with nearer-term cashflows (i.e. value stocks) more attractive. In addition, a higher cost of debt has a negative impact on earnings growth, especially for companies with large, predictable earnings way out in the future. Valuation metrics, such as forward earnings yield, have already begun to benefit from the new interest-rate environment, but are still cheap relative to history. As a result, value stocks can continue to perform over the long term.
  • Emphasising quality in uncertain times
    Higher interest rates also favour quality stocks. A looming wall of debt maturities is approaching as fixed-term loans come to an end. Companies with business models that are reliant on cheap borrowing will find the cash they have on their balance sheet might not be sufficient to cover increased refinancing costs. This situation is further intensified by sluggish economic growth and the financial strain on consumers, which creates an unstable economic landscape. In such a climate, an investment strategy that favours quality companies (at the right valuation) is essential. 
  • Focusing on the reality of price with momentum
    Momentum provides a different flavour by putting company fundamentals to one side. Momentum captures shifting market trends and sector leadership, which can happen quickly as we move into new regimes. In times of uncertainty and change, an exposure to momentum can ensure we remain invested in the stocks that emerge as winners.

Value, quality and momentum offer options to target above-benchmark returns. But why pick one when investors could mix them all into a single portfolio?

The benefits of an enhanced-index approach

An enhanced-index approach combines elements of passive and active investing, which can help clients achieve more stable, risk-optimised returns.

Diversification

Like passive investing, enhanced indexing offers strong diversification benefits. Global markets are currently extremely concentrated, with the ‘magnificent seven’ (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, and Tesla) comprising 28% of the S&P 500 Index. In times of market concentration, the diversification that investors can achieve from enhanced indexing is crucial. The beauty of an enhanced-indexing approach lies in not putting all your eggs in just one ‘factor’ basket. Harry Markowitz's principle of diversification, often heralded as the only 'free lunch' in investing, underscores the rationale behind this strategy. Diversifying across multiple factors in a robust and systematic manner should form the basis of every investor’s strategy.


Performance and risk management

The key reason for enhanced indexing’s growth in popularity is its ability to generate alpha in a cost-efficient manner while mitigating risks. One of the most compelling aspects of enhanced indexing is its risk-management capabilities beyond diversification. By incorporating factors such as value, momentum, or quality into its strategies, investors can benefit from enhanced-index portfolios that are less vulnerable to market downturns. In an era marked by economic uncertainty, we believe this risk-mitigation feature is invaluable for investors who are looking to preserve capital and minimise losses. Enhanced indexing also allows investors to capitalise on opportunities that go beyond the scope of a typical passive strategy, which creates the opportunity to generate greater returns. Simultaneously, enhanced indexing typically entails lower management fees than actively managed funds, making it a cost-efficient option.

And what about sustainability concerns?

A lesser-known benefit of enhanced indexing is that it enables investors to integrate sustainability into clients’ portfolios. Sustainability metrics, such as carbon footprint data, have become widely available in recent years. These quantifiable metrics share similar characteristics to multi-factor scores. As such, they can be easily incorporated into portfolios, without materially affecting factor exposure, diversification, or return benefits. The rules-based methodology of enhanced indexing can also ensure clients know precisely how their portfolios are constructed, why certain assets are included or excluded, and how factors are driving performance. Consequently, this transparency can reassure clients that their portfolio aligns with their sustainability values.

The best of active and passive strategies

An enhanced-index approach is not just a compromise between active and passive strategies – it's an investment opportunity that leverages the best of both worlds. It offers investors a method to potentially outperform benchmarks, while maintaining diversification, cost-efficiency, and a disciplined, long-term approach. In addition, value, quality and momentum factors tend to outperform over the long term, while also having an attractive outlook in the current economic environment. Therefore, enhanced indexing is an appealing option for investors looking to combine the sophistication of active management with the robustness of passive investing.