Passive investing has become the strategy of choice for thousands of investors. Satisfied with duplicating market returns instead of beating them, these investors buy index trackers or the like and own tiny pieces of thousands of stocks, earning returns from the upward trajectory of corporate profits over time via the stockmarket.
Observers need only to look at the industry flows of the past few years to judge how significant index investing has become. Yet by definition these strategies will only ever perform in line with their index, minus the small cost of investing.
What if investors could access an index-like portfolio, gaining market exposure with a similar risk profile to the benchmark, but add stock-selection insights in order to gain an information advantage? So-called research-enhanced index strategies present an interesting hybrid, combining the information advantage of active insights in order to seek consistent excess returns, but keeping to a portfolio construction and volatility level in line with the benchmark.
On the surface these portfolios look like the index, but under the bonnet they are driven by risk-constrained stockpicking. Since these enhanced index strategies have gained a foothold with advisers in recent years as a middle ground between passive and active, it’s worth taking a closer look at how they work and what makes them different to an index tracker.
A research-enhanced index strategy creates index-like characteristics with limited deviation from its market-cap weighted benchmark. However, it can bring to bear the resources of fundamental research analysts and sector specialists to apply stock specific views, taking marginal over- or underweight positions in companies relative to the benchmark.
Drawing on the insights of global analysts that go out and meet with company management – and using their assessments of future cashflows to put incrementally more focus on the stocks that should outperform over the long-term – makes research-enhanced index investing different to passive.
It’s not the purpose of these strategies to do a lot of asset allocation relative to the benchmark, or to take big sector bets. Rather, they are instead focused on driving stock-specific alpha by not owning as much of the expensive stocks and owning more of the cheap firms that are poised to grow earnings.
The key is in identifying the characteristics that have been shown to be the primary drivers of a company’s price, and thereby providing the potential to outperform in the long term. For example, forecasting long-term future cashflow streams can be a powerful tool. The farther into the future investors go with the business of forecasting of cashflows over time, the higher the alpha capabilities for differentiating companies.
A model using these inputs daily can rank hundreds of firms by order of the most and least attractive return profile to help a portfolio manager take a fundamental decision on which stocks to own and which ones to avoid.
Research-enhanced index strategies are designed to be region neutral, sector neutral within regions and style neutral, but can vary in their individual stock holdings more significantly within sectors in order to exploit active insights. Over longer periods, even small margins of outperformance over the benchmark can compound returns.
