What it means
A conventional index fund buys the whole index in the same proportions and accepts whatever the market delivers, minus a very small fee. An enhanced index fund starts from the same list of holdings but tilts a few positions up or down, or uses derivatives and securities lending to add a fraction of a percentage point of return.
The appeal is that the fund still behaves like the market for reporting purposes. Trustees and finance committees can point to a portfolio that will never wander far from the benchmark, while hoping to collect a small surplus each year that compounds meaningfully over a decade.
The measure that matters most is tracking error, which is the standard deviation of the difference between the fund's return and the index return. A pure tracker might run a tracking error of 0.1%, an enhanced fund typically runs between 0.5% and 2%, and a full active fund can run 5% or more.
Judging whether the enhancement works requires comparing the excess return against the extra risk taken, which is what the information ratio does. Dividing excess return by tracking error gives a number that lets you compare a fund adding 30 basis points cautiously with one adding 80 basis points recklessly.
Fees are the quiet decider. Enhanced index funds cost more than plain trackers but far less than active funds, and because the target excess return is small, a fee difference of a quarter of a percentage point can consume most of the intended benefit before it reaches the investor.
In practice
Real-world examples.
Example
A charity's investment committee wants index-like behaviour but has been told fees eat into its distributions. It moves half its equity allocation into an enhanced index fund with a 0.5% tracking error target, keeping the rest in a plain tracker so the blended fee stays low.
Example
A corporate pension scheme's consultant reports that its enhanced index manager has beaten the benchmark in four of the last five years by an average of 35 basis points. The trustees calculate that after the extra fee the scheme kept about 20 basis points, worth roughly $160,000 a year on their $80,000,000 equity book.
Example
A family office reviews an enhanced fund that lagged its benchmark by 0.7% in a single quarter. Because the mandate allowed a 1.5% tracking error, the adviser explains the shortfall is within the expected range rather than a sign the strategy is broken.
Formula
Calculation
Excess return = fund return - benchmark return
Information ratio = excess return / tracking error
Net excess return = gross excess return - additional fees
Worked example. An enhanced index fund returns 11.4% over a year while its benchmark index returns 10.9%.
Excess return = 11.4% - 10.9% = 0.5%, which is 50 basis points
The fund's tracking error over the period is 1.0%.
Information ratio = 0.5% / 1.0% = 0.5
The fund charges an annual fee of 0.25%, while a plain index tracker on the same benchmark charges 0.05%.
Additional fee = 0.25% - 0.05% = 0.20%
Net excess return = 0.5% - 0.20% = 0.30%
On a $5,000,000 investment the gross excess is 0.005 x $5,000,000 = $25,000, the additional fee is 0.002 x $5,000,000 = $10,000, and the investor keeps $25,000 - $10,000 = $15,000. That $15,000 is 0.30% of the $5,000,000 invested, confirming the net figure. The question for the investment committee is whether $15,000 a year is adequate compensation for the possibility that the fund underperforms the index in a bad year.Case study
Seen in the real world.
The Ardenwood Foundation is a fictional, illustrative grant-making body with a $60,000,000 endowment that funds roughly $2,400,000 of grants a year. Its board had spent a decade in plain index funds and was frustrated that returns were, by definition, exactly average.
Rather than moving to active management, which the board considered too unpredictable for a grant budget that had to be set a year in advance, Ardenwood allocated $20,000,000 to an enhanced index fund with a stated target of 40 basis points of excess return and a 1% tracking error cap. Over five years the fund delivered an average of 45 basis points gross and 28 basis points net of the extra fee, adding about 0.0028 x $20,000,000 = $56,000 a year to the endowment.
The illustrative board's verdict was mixed but honest. The extra money was real and paid for roughly two additional small grants a year, yet in one of those five years the fund trailed the index and the board had to explain to its donors why an "index" fund had lost to the index. The experience taught them that enhancement is a probability, not a promise.
Watch out
Common mistakes.
- Believing an enhanced index fund cannot underperform its benchmark, when the same deviations that create excess return can just as easily subtract from it.
- Comparing the fund's headline fee to an active fund and concluding it is cheap, without comparing it to the plain tracker that is the real alternative.
- Judging the strategy on a single quarter, when the excess return is small enough that random noise dominates over any period shorter than several years.
Questions
People also ask.
How is an enhanced index fund different from a smart beta fund?
Smart beta funds follow a rules-based alternative index and can deviate substantially, while an enhanced index fund keeps the standard benchmark and makes only small, tightly controlled deviations around it.
What tracking error should I expect?
Most enhanced index funds run between 0.5% and 2%, and the mandate should state the intended ceiling so you can check the manager is staying inside it.
Is the extra fee worth paying?
Only if the fund's long-run net excess return is reliably positive after that fee, so ask for at least five years of returns measured against the same benchmark before deciding.
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