"Enhanced" Index Funds

They say that imitation is the sincerest form of flattery. This is undoubtedly the logic that lies behind the appearance in recent years of a strange creature known as the "enhanced index fund". In a nutshell, the sales pitch for the great majority of these funds comes down to something like this: "we're really an index fund, but we deliver slightly better returns than the index." Hmmm…As my three year old says, "sounds suspicious. Let's investigate."

Enhanced index funds basically take one of two approaches in their attempts to deliver "better than the index" returns. For some of them, superior performance basically comes from superior security selection. For example, some of these funds try to tilt their "indexed" portfolios towards those companies in the index which they believe to be undervalued. Others take a different approach, and try to use optimization techniques to identify a portfolio of companies that will match the volatility of their target index, while delivering superior returns.

The second major approach taken by the enhanced index funds is the use of leverage and/or derivatives. For example, an enhanced index fund could spend ten percent of its cash investing in index futures (which enable you to control $100 of the index for $10 of up front cost) while investing the remaining ninety percent in what they believe to be underpriced bonds, in the hope that their profits on the latter lead to above equity index returns. A simpler strategy would be to simply write (that is, sell) call option contracts on the equities held in the index portfolio. As long as these call options never get exercised by their holders (that is, as long as they stay "out of the money"), the profits from the option contract sales generate returns above the target index. A final technique that falls into this category is what is known as cash/futures arbitrage. In this case, the portfolio manager would invest in either futures contracts that are tied to the target index, or in the underlying shares, to take advantage of (that is, to arbitrage) any pricing discrepancies between the two. In this case, it is the resulting arbitrage profits that are expected to deliver enhanced, above index returns.

All this sounds good in theory (though perhaps a little more like active management than many index investors may like); the next logical question is how these funds have faired in practice.

Because it is one of the oldest of the enhanced index funds (and because it comes from one of the leading firms in this area) we've decided to take a close look at the Rydex Nova Fund (RYNVX). The fund's objective is to deliver returns that are 50% higher than its target index, which is the S&P 500. In exchange for this, Rydex requires a large minimum investment ($25,000, though this may be less if you invest via a registered investment advisor), and charges annual expenses of 1.34% -- very substantially more than Vanguard or an iShares ETF that tracks the same index.

Since the fund was launched in 1993, its cumulative return has been 124% of the S&P 500's. During the big downturn in 2000, its fall was 193% of the S&P 500's. Finally, year to date in 2001, its loss is 139% of the S&P 500's.

Let's look at it a slightly different way. Between January, 1995 and December, 2000, the Nova Fund had an average annual return of 24.77%, with a standard deviation of 26.01%, and a downside deviation (assuming an 8% target return) of 29.56%. In other words, if you owned this fund during that period, you received .95% of return per unit of standard deviation risk, and .84% of return per unit of downside deviation risk. During this same period, the S&P 500 had an average annual return of 22.66%, with a standard deviation of 18.03% and a downside deviation (again, using an 8% target return) of 26.30%. In other words, the S&P 500 delivered 1.26% of return per unit of standard deviation risk, and .86% of return per unit of downside risk. Considering the difference in expenses between the Nova Fund and what you would have paid for Vanguard's S&P 500 fund, and you can't escape the conclusion that the latter was the better deal -- especially when you seen how the Nova Fund actually fell by more than its stated target of 150% of the S&P 500 during the big 2000 downturn (technically, this is known as "tracking error").

So we're dead set against enhanced index funds, right? Generally, yes, but with one very important exception. Lumped into the general category of enhanced index funds are funds whose objective is to deliver returns that are the inverse of the returns on the S&P 500. In other words, their objective is to have a correlation with this index that is equal to (1.0). Regular readers of The Index Investor can imagine how our eyes twinkle when we read that. Why? Recall that the risk of a portfolio is a function not only of the riskiness of each individual asset class, but also of the extent to which their returns move together (that is, their correlation). From a portfolio diversification point of view, an asset with a correlation of (1.0) is very attractive, because its returns will tend to be positive while other's are negative. An asset with a negative correlation will also help the portfolio overcome the nasty tendency for asset class correlations to move closer to positive 1.0 when markets move down (as we have seen over the last 18 months). To put these "inverse return funds" into perspective, here are some other asset class return correlations with the S&P 500 over the January, 1995 to December, 2000 period: NAREIT Index, .24; Goldman Sachs Commodity Index, .03; Lehman Brothers Aggregate Bond Index, .22; and Salomon Brothers Non-U.S. Dollar Government Bond Index, .08. If these inverse return funds can deliver on their promise, they have the potential to really add something to your portfolio. So our next task is to see if these funds actually deliver on what they promise.

Of the few inverse return funds that exist, one of the oldest is the Rydex Ursa fund, which was launched in 1994. Until the past 18 months, it has been hard to tell whether or not this fund would be able, in a down market, to deliver on its promise of returns that were opposite those on the S&P 500 (previously, all we had was ample evidence of the fund's ability to do this in a rising market). Well, the jury is now in, and we like what we see. Since its inception, the Ursa fund has delivered cumulative returns of (10.00%) versus 15.95% for the S&P 500. During the year 2000, it delivered returns of 16.44%, compared to the S&P 500's (9.11%). And this year to date, it has 23.02% versus a loss of (7.61%) for the S&P 500. By comparison, a similar fund, the Potomac U.S. Short Fund (PSPSX) has delivered year to date returns of 18.65%.

Our conclusion: in this case, the expenses of 1.37% per year (for the Ursa Fund), are more than offset by the potential diversification benefits this inverse fund delivers. For that reason, and now that they have proven themselves in a big downturn, we are going to consider inverse funds as a separate asset class in next year's rebalancing analysis.