Enhanced index funds. which invest based on benchmark indexes like the S&P 500, give the promise of market-matching or even market-exceeding returns with reduced risk. But can enhanced index funds really deliver on this sparkling promise of low-risk rewards? Read on to find out. (To read more on index funds, see Index Investing . The Lowdown On Index Funds and You Can’t Judge An Index Fund By Its Cover .)

Background

The index fund as we know it today was started by John Bogle in 1975 through his Vanguard Group. His main goals were very simple: He wanted to offer individual investors the lowest fees out there, to avoid trying to outsmart the market and to represent the market with as little distortion as possible. Over time, his theories proved their worth in the only way that matters — investment returns. (Keep reading about active management in Words From The Wise On Active Management .)

In theory, index funds attempt to track the overall market without bias. Investing in a basket of 500 of the largest companies in the world is considered a broad enough investment to resemble the performance of the overall economy, and because beating the market is such a difficult thing to accomplish, reducing total expenses and fees has become one of the most important goals individual investors have. (Find out what is involved in beating the market in What does it mean when people say they beat the market? How do they know they’ve done so? )

Besides passively tracking the index, there weren’t any real arguments that people could make against index funds; investors knew going in that they would only perform as well as the markets performed. But perceptions about index funds changed during the stock market decline that took place between the spring of 2000 and October of 2002. Back in March of 2000, when the indexes were at all-time highs, the valuations of many top companies were inflated, going for 40- or 50-times current earnings or more.

Highlighting this is the fact that, at the time, the top 20 stocks in the S&P 500, as measured by market cap. comprised well over one-third of the total value of the S&P 500 index. which is capitalization-weighted. Because valuations were rising at a faster rate than actual earnings, index funds became skewed toward the largest companies. When the indexes began to fall, it was the large-cap leaders that were hit the hardest, as valuations had to come back in line with the more modest expectations of the time. Index funds experienced awful returns for several years, and when prices finally began to recover, the large-cap companies took much longer to return to price levels of the past than the small-cap and mid-cap stocks did. (To find out more about his subject, see Determining What Market Cap Suits Your Style and Market Capitalization Defined .)

Does Enhanced = Actively Managed?

The mutual funds and exchange-traded funds (ETFs) that market themselves as enhanced index funds will usually use the S&P 500 or another broad-based index as the base for security selection. Essentially, the managers of these funds appreciate the core theory of index investing, but feel that better returns can be achieved, or variations can be reduced (i.e. lower volatility ), by not holding such a high percentage of the largest stocks by market cap. Some funds even going so far as to make the blanket statement that these largest companies are overvalued .

So these managers eschew the passive approach to tracking an index in favor of a semi-active approach to portfolio management. They will establish investment selection criteria based on metrics such as company revenue. net income. dividend rates. price/book ratio. They may also purchase flat percentages of all companies in the fund (regardless of market capitalization) or use complex computer models to find sectors within the index that will yield market beating performance. (To find out how to set up your portfolio, read A Guide To Portfolio Construction . Major Blunders In Portfolio Construction and How Portfolio Laziness Pays Off .)

Other funds will employ an enhanced cash strategy, whereby derivatives are purchased on the index itself to exhibit the return potential that would be earned on total fund assets; meanwhile, the remaining cash is invested in various fixed-income instruments. This strategy offers some downside protection but opens itself up to interest rate risk above and beyond what an all-equity portfolio would exhibit.

And then there are even some funds that employ a tax-enhancing strategy, often in addition to a core investing methodology, which amounts to doing some balancing of gains and losses within the positions to limit capital gains distributions to investors.

And finally, there are a few dozen open-ended mutual funds that assert themselves as enhanced index funds. Many of these employ the leveraged cash strategy discussed above. The PowerShares Capital Management group, for example, has a whole family of exchange-trade funds based in standard indexes but with methodologies that allow for discretion in what securities are purchase, and in what amounts. For example, the PowerShares FTSE RAFI U.S. Portfolio ETF uses as its underling index the RAFI 1000 index, which includes in its selection criteria levels of company cash flow. sales, book value and dividends. (To keep reading on this subject, see Mutual Fund Basics and Open Your Eyes To Closed-End Funds .)

What are the risks?

The biggest risk to investors is that these funds are essentially actively managed, meaning that someone is choosing what to include and how much of it should be there. Therefore, instead of just facing market risk (the risk that investments will fall in value as stock indexes fall in value), the investor is also exposed to manager risk. Wrong choices by managers could lead to underperforming the passively managed index fund. (Find out more in Should You Follow Your Fund Manager? and Why Fund Managers Risk Too Much .)

The expense ratios and turnover rates are also higher than what is found in the standard index fund group, as the company structure is going to more closely resemble a standard mutual fund, with increased marketing, trading and research costs and higher overhead than traditional index funds. Most enhanced index funds have expense ratios between 0.5% and 1%, which is less than the average mutual fund but far more than pure index funds. As a basis of comparison, investors should use the iShares S&P 500 ETF, which has an expense ratio of 0.09% annually, and the Vanguard 500 Index, which has an expense ratio of 0.18%. Both funds turn over only 7% of holdings per year, while some enhanced index funds have turnover rates of 100% or more.

Proponents of enhanced index funds often claim that the companies who dominate the indexes in terms of market cap are overvalued, and that a flatter ownership structure within fund holdings is the way to go. What is missed in this claim is that, according to John Bogle’s speech at Bullseye 2000 Conference, in 2000, the 10 largest stocks make up 20% of the total value of the S&P 500. In 1964, however, the top 10 made up 38.5% of the index. And in 1950, the 10 largest made up a whopping 51% of the total index,

So the trend over time has already been toward more breadth in the markets. Plus, if the stock markets go through a multi-year period where valuation multiples expand across the board, enhanced index funds that don’t hold market-matching security weightings could miss out on big gains — gains that would be had by investors in traditional index funds.

Value Funds?

In reality, some enhanced index funds are thinly-veiled value funds. as value funds also invest primarily in stocks with higher net income figures, dividend yields or other criteria designed to find investments that are undervalued. Investors should be very wary of purchasing an enhanced index fund with the idea that they are buying the market.

Investors may want to consider enhanced-index funds as a supplement to a standard index fund rather than a replacement. But first and foremost investors should take the time to understand the methodology being used; owning one mutual fund with a value-basis over one with an enhanced-index focus might not be a diversification technique as much as an unwanted overlapping of strategy.

Parting Words

So far enhanced index funds do not have sufficient performance histories to determine whether they can really deliver. Using one bear market as a justification for their existence is not enough; investors should continue to evaluate their efficacy through good times and bad. One thing that is certain is that many people on Wall Street are very good at wrapping up old things with new paper and selling them to unknowing investors. Before you invest, carefully review the available funds to determine which ones have a real strategy, and which are just trading on a good name.