- The Washington Times - Thursday, October 24, 2002

It sounds like a great idea taking an index fund and managing it more actively to improve returns. But most investors haven't been tempted by enhanced index funds which haven't lived up to their billing, anyhow.
Similar to pure index funds, the enhanced portfolios track the performance of a stock index, but they also seek to boost returns with more active management techniques, such as overweighting some of the stocks.
It seems ideal for investors looking for alternatives after three years of losses.
"People are asking, 'Should I stay in my index fund?'" said Stephen Wetzel, a financial planner in Yardley, Pa., and professor at New York University's School of Continuing and Professional Studies.
But analysts say that investors haven't been making wholesale switches to the enhanced funds. They say that's because the portfolios offer only slightly better performance, if at all, while carrying stiffer expenses and higher risk.
In 2002, enhanced index funds through September had $2.1 billion in net outflows, according to Boston-based Financial Research Corp. By contrast, the largest pure index fund, the Vanguard 500 Index, alone had net inflows of $656 million through Oct. 2, according to AMG Data Services.
"It's not really a way to protect people from the worst ravages of the bear market," said Scott Cooley, analyst for fund tracker Morningstar.
Pure index funds became particularly popular in the late 1990s, offering respectable returns during the market upswing.
But index funds have suffered in the three-year market downturn. The Vanguard 500 index fund, for example, lost its ranking last month as the nation's largest equity or bond fund after investors seeking refuge in bonds flocked to the Pimco Total Return Fund.
Enhanced funds seek to improve returns by trying to take advantage of market timing, overweighting some of the stocks, or buying stock index futures while investing in some short-term bonds.
But the added tinkering tends to yield more expenses and taxes owing to higher stock turnover without any guarantee that the funds will do better than pure index funds.
Indeed, the more than 50 enhanced index funds tracked by Morningstar had an average loss this year of 24.37 percent, worse than the average 23.22 percent decline for pure index funds.
Among the enhanced funds that specifically followed the Standard & Poor's 500, losses averaged 27.8 percent, compared with 26.4 percent for the pure funds. During that same period, the S&P; 500 dropped 29 percent.
Some financial planners say that enhanced funds are worth considering as part of a diversified portfolio, but recommend their use for tax-deferred accounts, such as 401(k) plans, to avoid annual taxable gains from high turnover.
They also urge investors to examine prospectuses closely to see how an enhanced fund seeks to track index performance, since approaches vary widely, affecting fees, taxes and overall returns.
"I would want one where the manager has really added value," Mr. Cooley said, citing Vanguard's Growth and Income Fund. Its managers use quantitative models to determine which stocks to overweight and it has outperformed the S&P; 500 for 10 years.
But others say that investors seeking more returns would be better off with actively managed funds, which don't constrain managers to index investing. They note that enhanced funds tend to sacrifice the main draw of pure index funds low costs and less volatility.
"The problem is, any time you get too enhanced, you run the risk that you do with any regular fund that it's not matching the performance of the index," Mr. Wetzel said. "You might as well pick actively managed [funds]."

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