The surge in cheap money encouraged investors to take on greater risk without necessarily focusing on fundamental valuations.
However, the current environment has shifted dramatically. Higher interest rates, rising inflation, and an uncertain economic backdrop have forced investors to become more discerning in their approach.
In this new reality, fundamental valuation metrics — the cornerstone of sound investment practice — are being rewarded once again. Against this backdrop, we believe there’s a compelling case for enhanced index strategies.
What’s enhanced indexation?
Enhanced indexation is an investment strategy that combines the benefits of passive investing with the potential for excess returns — or alpha — derived from targeted, systematic exposures to certain risk premia.
Leveraging data analysis and statistical models
By leveraging data analysis and statistical models, enhanced index portfolios are constructed to take advantage of key drivers of stock performance namely, valuation, quality, and momentum.
The goal is to achieve above-benchmark returns while maintaining a controlled risk budget and adhering to broad index constraints (e.g., stock, country, or sector exposure).
Among the best-recognised risk premia are:
- Quality – companies with strong financial health and stable earnings.
- Value – undervalued companies trading below their intrinsic value.
- Momentum – companies with strong recent performance, which are expected to perform in the short-to-medium term.
Stocks selected for enhanced index portfolios are chosen from broad market indices, with their weights driven by their exposure to these factors. This rules-based approach aims to harvest excess return opportunities while minimizing exposure to untargeted sources of risk and maintaining a consistent tracking error to a given benchmark index.
The key to success lies in how each target factor is defined, the optimal transfer of those factors into the portfolio, and how well unintended risks are managed. This is what we believe distinguishes an effective enhanced index manager.
Why now for enhanced indexation?
Enhanced indexation can take various forms, but we believe a multi-factor approach incorporating quality, momentum, and valuation should be most appealing to investors—particularly in current market conditions. Here’s why:
1. Emphasising quality in uncertain times
In uncertain times, companies that are fundamentally strong and financially resilient become even more attractive. As the cost of debt rises and refinancing pressures mount, companies with stable earnings, lower debt, and sound business models—the quality stocks—are poised to outperform.
High interest rates disproportionately affect companies that rely on cheap borrowing. The appeal of quality stocks becomes especially evident, as their efficient capital structure and investment policies positions them to weather rising refinancing costs and sluggish economic growth.
2. Focusing on the reality of price with momentum
Momentum provides a different perspective by putting company fundamentals to one side.
In today’s market, where sector leadership can shift rapidly due to macroeconomic changes, geopolitical tensions, or technological breakthroughs (such as AI), momentum offers a way to stay ahead of the curve and ensure that portfolios remain invested in the market’s emerging leaders.
3. Valuation: preventing overpayment for quality and momentum
Valuation is often seen as a strategy focused on identifying undervalued stocks. However, in enhanced indexation, its real power lies in ensuring investors do not overpay for the combination of quality and momentum.
In an environment where some growth stocks and high-quality companies have continued to outperform—even in the face of rising interest rates—the risk of overvaluation is ever-present.
Value acts as a balancing mechanism, helping investors identify stocks that, despite strong quality or momentum characteristics, may have become overpriced relative to their fundamentals.
By incorporating valuation, enhanced indexation ensures that investors are not simply buying into stocks because of their strong past performance or attractive fundamentals—but are also paying a fair price.
Why pick just one factor when investors can combine all three into a single portfolio?
The benefits of an enhanced index approach
Enhanced indexation offers a unique combination of active and passive investing benefits. Below are the key advantages that make this approach particularly well-suited to today’s market environment:
1. Diversification in an increasingly concentrated market
Like passive investing, enhanced indexation offers strong diversification benefits.
The beauty of an enhanced index approach lies in not putting all your eggs in one ‘factor’ basket. Harry Markowitz’s principle of diversification, often heralded as the only 'free lunch' in investing, underscores the rationale behind this strategy. Diversifying across multiple factors in a robust and systematic manner ensures that risk-aware positions are taken in segments of the market subject to the effects of concentration. We believe such pragmatism should form the foundation of every investor’s strategy.
2. Risk management and cost efficiency
Looking beyond the first-order principle of diversification, a well-constructed enhanced index portfolio actively manages untargeted risks that can arise in any active portfolio. Events like China’s post-COVID reopening, shifting interest rate expectations, or uncertainty around US politics can illuminate significant exposures that investors may not explicitly intend to take. A well-constructed enhanced index portfolio mitigates these risks, ensuring factor tilts are deliberate rather than accidental.
Importantly, this systematic, rules-based approach delivers alpha without the high fees of traditional active management. Investors can benefit from outperformance at a significantly lower cost, making enhanced indexation a potential capital-efficient alternative for long-term success.
In summary: combining the best of active and passive strategies
Enhanced indexation is an investment opportunity that leverages the best of active and passive investing.
It offers investors the potential to outperform benchmarks while maintaining diversification, cost-efficiency, and a disciplined, long-term approach.
Furthermore, quality, momentum, and valuation factors tend to outperform over the long term. They offer diversified return drivers and possess compelling characteristics, especially in the current economic climate.
For investors looking to combine the potential for outperformance offered by active management with the robustness of passive investing, enhanced indexation is an appealing option.