Edwin J. Elton (NYU), Martin J. Gruber (NYU), and Andre B. de Souza (St. John’s University) have a new study about “enhanced” index funds. Of course the whole idea of index funds is that they involve no enhancements at all; they just track an index like the S&P 500. But “enhancements” have become increasingly popular in a “have your cake and eat it, too” fashion, allowing investors to have the low expenses of an index and some of the judgment of informed stock-picking. Since the benefit of index funds for investors is that over time they consistently outperform stock-picking funds, the results here are not surprising. “Enhanced” funds seldom earn their higher fees.
When we examine returns pre-expenses, we find that enhanced index funds outperform index funds at a statistically significant level. Furthermore they outperform the index they follow (they add value). For enhanced index funds, much of this excess performance is explained by beta levels greater than one with the prospectus index (levering) and tilting to small stocks or value stocks. When we examine post expense returns (returns to the investors) enhanced index funds still outperform index funds but at an insignificant level. However, when we use well established rules for selecting the best fund from among all those following an index (such as picking the one with the lowest expense ratio) index funds have superior performance.Are Enhanced Index Funds Enhanced?