The rationale behind index investing is that if you can't beat the stock market, join it. But Asha Joshi, portfolio manager for the


Payden Market Return fund, thinks she has found a way to do both.

Joshi's fund employs a so-called enhanced index strategy that entails mixing futures contracts and bonds in order to beat the

S&P 500

. So far her recipe has proven successful, as the fund has beaten its bogey, however slightly, in each of the past four years. The fund's three- and five-year annual returns are 4.29% and -2.68%, beating the index by 70 and 46 basis points.

Because the fund seeks to enhance its returns by actively managing its bond portfolio, the fund could have trouble besting its benchmark during a rising rate environment -- kind of like the one the market is facing now.

checked in with Joshi to learn more about enhanced index investing and to see if the fund can beat its benchmark for a fifth straight year even if interest rates do continue their upward climb.

What is an enhanced index strategy?

An index strategy is designed to leave you with the index return less expenses. An active strategy, where the manager selects individual stocks, looks to beat the index after expenses.

The enhanced strategy looks to beat the index, but it also looks to give you index-like consistency. So the variation around the index should be minimal relative to an active strategy.

Could you explain your fund's enhanced index strategy?

Our strategy is somewhat unique in that it uses bonds to beat stocks. We take a portfolio of short-term bonds and overlay S&P 500 futures on top of it. For every $100 we take in, we purchase $100 worth of equity exposure through S&P futures contracts.

The futures give you the S&P 500 return less the financing cost, and that financing cost is short-term interest rates, which is basically Libor -- the London InterBank Offered Rate. So if you just buy S&P 500 futures, your return is the S&P 500 minus Libor.

It's important to note here that buying futures contracts is more like an implied borrowing. You don't have to put up the actual cash. Instead, you can just use a $100 portfolio as collateral. In our case, we use a short-term bond portfolio that we actively manage as collateral.

When you put it all together, you are left with: (1) the S&P 500 futures return minus the Libor you pay to own them; (2) the Libor you earn from buying short-term bonds plus the alpha, or added value, you receive for managing the bond portfolio.

When you do the math, the Libor on both sides offsets each other, so you end up with the S&P 500 plus the additional value added.

So how are you able to add value on the bond side to goose the returns on the stock side?

That is where our real expertise lies. The firm has successfully beaten Libor since our inception over 20 years ago.

We achieve that through managing three major variables. First, we add value by managing duration, or interest rate risk. The second way is through yield-curve positioning. Finally, the third and major way we are adding value today is through sector management. That's where we earn added yield above Treasury rates by buying nongovernment paper like mortgage and asset-backed securities, short-term corporate bonds and even small percentages of emerging markets and high-yield bonds. We can add value there by doing credit work.

When interest rates were rising in the late 1990s, as they are doing now, your fund had trouble beating the index. What happened then?

When interest rates rise, longer-term bonds will underperform Libor -- that's just the nature of the beast. And the longer your duration, the greater the underperformance.

But the good part about being in bonds is that when interest rates rise, you are reinvesting at higher yields. So if you give yourself enough time, you will eventually make up that difference.

So in the short run there could be periods where we might underperform the benchmark, but over time we believe that we can beat the index without taking on too much volatility.

Is there any leverage in your portfolio?

No. We do not use any leverage. For every $100 we take in, we have $100 worth of exposure to stocks and no more.

If you are buying foreign bonds to beat the benchmark, do you hedge the currency risk?

Depending on our outlook we may take on some currency exposure, but by and large we limit it strictly, since currencies are volatile. And if our goal is to limit volatility, then we don't want to take on too much currency risk.

Can this enhanced strategy be used on any index, or just the S&P?

This strategy can be used on any index that has liquid futures contracts. So I suspect we may be seeing more of it in the future.