Enhanced Index Funds

Before trying to understand enhanced index funds, you would probably want to know what an index fund is in the first place! Basically, mutual funds are index funds that have the intention of tracking returns within a given portion of the market. The index, then, is a group of securities which represents that particular portion of the market, be it stocks, bonds, etc. Indexes are developed by companies such as Dow Jones or Standard and Poor’s. For the most part, indexed funds are considered to be ‘passive funds’ in that they try to mirror what is going on in that segment of the market they are tracking. Investments are then made based on how the market is actually moving as opposed to predicting future movement. Enhanced index funds, on the other hand are the perfect blend of active and passive indexing.

How Enhanced Index Funds Vary
Enhanced index funds do follow market trends in much the same way as index funds but they add a bit of active management into the mix. Whereas index funds play it safe by trading on what the market is actually doing, enhanced funds use a variety of other techniques. You might want to think of enhanced indexing as an improvement on indexing in that it allows for an emphasis on performance. For example, enhanced index funds use customizing indexes which don’t rely on the conventional commercial indexes (i.e. Dow Jones, or S&P’s). Enhanced index funds also use different rules of exclusion, trading strategies and may even use different trimming strategies as well. Active management of funds can also either reduce or eliminate altogether the cost of indexing. Keep in mind that there is a cost involved in tracking errors and/or transaction fees.

Enhanced Indexing Strategies
As mentioned above, there are a number of strategies that are employed to enhance (or actively manage) an index. Some of these strategies include Index Construction Enhancements, Enhanced Cash, Exclusion Rules and Trading Enhancements. Each strategy allows for variations from the ‘norm’ and will allow for trading when certain market triggers are realized. Sometimes a strategy is in place for leveraging while other times the strategy might be to use dynamic as opposed to static indexes. Exclusion rules would eliminate companies that might not perform well based on securities that would be most likely to reduce performance based on financial difficulties such as in instances of bankruptcy and/or excessive debt. Picking and choosing which securities to add to a portfolio allows for active management while still trying to adhere as closely as possible to the index.

Weighing the Pros and Cons
Although enhanced index funds can yield much greater profits through active management strategies, there is also the potential for greater loss. Bear in mind that passive funds are traded based on the current market and not on future projections. Enhanced funds often trade based on a greater degree of risk because future trends are taken into account. Passive indexing, on the other hand, is most often seen as a safer alternative even though there isn’t the potential to realize a great amount of profit. Passive indexing also has costs associated that often void out any profits so that the only capital remaining might be the initial investment. Even so, while not as risky as trading ventures, enhanced index funds still have a certain amount of risk. If you are not quite brave enough to trade futures but want a bit more profitability than can be offered by index funds, enhanced index funds might be the happy medium you are looking for.

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