At Dynasty, we have long endorsed an investment approach that blends active and passive portfolio management to achieve optimal, risk-adjusted returns over the longer term. As an evolution within our portfolio construction, we have recently included three Enhanced Indexation Funds in our house-view global equity portfolios.
Explaining Enhanced Indexation
Enhanced Indexation is an active-passive hybrid investment strategy designed to deliver returns modestly above a chosen benchmark index while maintaining risk characteristics closely aligned with that index. The strategy sits between pure passive tracking and fully active management on the active-passive spectrum. It has become increasingly used by asset managers and institutional portfolios where cost efficiency, risk control, and benchmark awareness are critical. The goal is to deliver the best of both worlds – the lower costs associated with passive funds, but with systematic, low-risk active decisions to outperform the index, while maintaining a similar risk profile.
How Enhanced Indexation Works
Rather than replicating the index exactly, the manager introduces controlled tilts away from index weights using rules-based or quantitative techniques. An Enhanced Indexation Fund will generally try to keep close to a market index (such as the MSCI World) to give investors broad market exposure, however, the fund manager will have the discretion to make small adjustments by slightly increasing or decreasing exposure to certain stocks.
Common Sources of Alpha (Outperformance)
Individual stock adjustments are tightly controlled, and common sources of alpha include: factor tilts such as Value, Quality, Momentum, and Low Volatility; small-security mispricing; optimised stock selection; and rebalancing, trading, and transaction-cost efficiencies.
These tilts are designed to be diversified with low conviction, avoiding large active bets.
The Performance Profile
Enhanced Indexation is not designed to outperform significantly in any single year, but to add small, consistent alpha over time.
As we mentioned earlier, the adjustments would typically be relatively minor, seeking to eke out between 0.5 and 1 percentage points in additional return over 12-month periods. While this sounds small, it can be enough to help compensate for tracking errors as well as fees – allowing investors to get close to index performance net of fees and offering marginally higher compounded returns in the longer term.
Advantages and Limitations
Enhanced Indexation does come with some limitations, including that alpha is capped; there is potential for underperformance against the overall index due to strong factor reversals; and the fact that returns can lag in markets favouring high-conviction active bets.
However, in our view, the advantages of Enhanced Indexation outweigh the limitations, with the major benefits summarised as follows:
- Cost-efficient alpha generation
- High transparency and predictability
- Strong benchmark alignment
- Reduced manager-specific risk
In Summary
Notwithstanding the above risks, we are pleased to now offer Enhanced Indexation as another component within our portfolio construction. In an environment since 2020 where markets have experienced ongoing disruptive events such as COVID-19 with its associated zero interest rates; the Russian invasion of Ukraine in February 2022 which then turbo charged inflation; the surge of AI since 2023; and, more recently, the US introduction and weaponisation of tariffs – the MSCI World Index has been a challenging benchmark for most active managers to meet, let alone outperform.
As such, Enhanced Indexation now forms a meaningful 25% component of our house-view global equity portfolios as a pragmatic way to balance broad market exposure with the opportunities to carve out marginally higher returns.
Importantly, we are also in a position to make these instruments available to clients on a standalone basis on our selected global administration platforms, and we will be switching a portion of clients’ portfolios should the concept of Enhanced Indexation resonate with them and where the associated costs, such as CGT, justify the change.
