Dear Dagen: Enhanced-Index Funds Are Neither Enhanced Nor Index Funds

These funds try to improve on index returns by adding active management.
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What is your take on enhanced-index funds like (SSFFX) Scudder Select 500? Are these true index funds or are they actively managed funds disguised as index funds? Are these the future trend for index funds? -- Ed Cheng

Ed,

Many enhanced-index funds attempt to defy the basic premise behind index investing: An active manager who is picking stocks can't consistently beat the market. Instead, these funds try to combine both indexing and active management into one fabulous package. The results so far have been mixed.

As the name indicates, enhanced-index funds try to closely track an index while somehow improving upon that benchmark's returns. Many of these funds use active management -- stock or bond selection -- to boost the underlying index's returns, while others employ leverage.

These funds will usually start with an index, typically the

S&P 500

, as the beginning universe of stocks. A manager might then weed out companies he thinks will underperform the index and overweight the ones that will outperform. Or the manager might tilt the portfolio's industry weightings in favor of sectors he believes will excel.

However, these managers aren't trying to pick individual stocks using sheer brain power and fundamental analysis. They'll typically use a quantitative approach involving complex mathematical computer models to find undervalued or overvalued stocks or inefficiencies in a market.

Scudder Select 500, for example, starts with all the companies in the S&P 500 index. The management team then ranks those stocks according to factors including growth potential and price momentum. The stocks are divided into quintiles, and then the bottom quintile (20% of the index) is cut from the fund. This approach is supposed to eliminate any stocks that are expected to underperform. The fund, launched in May, has a 13-week return of -3.8%, slightly better than the - 4.8% return for the unenhanced

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Vanguard 500 Index fund, according to

Lipper

.

Other enhanced-index funds try to improve an index's returns through active fixed-income management. The

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PIMCO StocksPlus fund invests in S&P 500 index futures contracts, but the majority of the fund's assets are actively managed in a portfolio of short-term, investment-grade bonds. Futures allow an investor to make a big bet on the underlying stock index with a relatively small amount of money, which leaves plenty of cash to invest in fixed-income instruments.

It's through the active management of the bond portfolio that the manager tries to add some incremental return above that of the underlying index. Its one-year return is 34.5%, a hair behind Vanguard 500 Index's 36.4% performance.

Lastly, some juiced-up index funds use leverage or exchanged-traded derivatives to attempt to beat their benchmarks.

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Rydex Nova tries to beat the S&P 500 by 50% by buying stock index futures and options along with actual stocks.

This year the fund is up 7.4%, and is not even meeting, much less beating, the 7.8% price rise of the S&P 500 index. Last year, the Rydex fund returned 35.1% versus a 28.6% return for the S&P, according to Lipper. That's a margin of 22.7%, which is less than half its 50% goal.

High Expenses and Turnover

Part of the problem with any of these funds is that they can have higher expenses and turnover, which a plain index fund tries to avoid. Most quant models generate a lot of turnover.

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American Century Income & Growth, an enhanced-index fund that employs quantitative stock picking, has an annual expense ratio of 0.69% and turnover of 86%. By comparison, the Vanguard 500 Index carries an expense ratio of 0.18% and turnover of 6%.

Extra turnover can increase the fund's trading costs, which come right out of the fund's net asset value, and result in higher taxes for shareholders.

But at least this American Century fund has a five-year record. Many of these enhanced-index funds are only a few years old. With pure index funds doing so well in recent years -- garnering attention and assets -- the enhanced varieties have become increasingly popular. At the end of 1997, enhanced-index funds commanded 0.53% of the U.S. fund industry's assets, according to

Financial Research

in Boston. At the end of 1998, that share has risen to 0.77%. By the end of July, that percentage had grown to 0.86%.

From a marketing standpoint, the approach sounds great. You can get index returns and then some. "These funds are going to do well if the indexes are doing well," says Financial Research analyst Dave Haywood. But once the market starts to do badly, however, these managers and their models may or may not be able to add value.

What's In a Name?

Even though the word index is in the name, I would argue that these funds shouldn't be called index-anything. An index fund should give you the same performance and volatility characteristics of an index. That's it. But these funds are using elements of active management.

Vanguard's

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Growth & Income fund would fall into this category, but the indexing giant doesn't call it an enhanced-index fund. "We would call it active quantitative management," says Jim Troyer, a principal in Vanguard's core management group. "We don't like the term

enhanced-index fund because we think it implies no greater risk but extra return." It's like saying: "There's no such thing as being a little dead."

If you're still interested, approach these funds as actively managed portfolios. Unlike index funds, you are at the mercy of a manager's (or his computer model's) stock-picking ability.

If you borrow money from a bookie and buy some index funds, that's enhanced-index investing too. But that's not necessarily the best way to invest your money.

Send your questions and comments to

deardagen@thestreet.com, and please include your full name.

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