Investors are always seeking new investment opportunities with better risk-adjusted returns. Enhanced indexation is one such strategy, which is superior to passive yet still complementary to a traditional fundamental strategy.
Lejda Bargjo, Client Portfolio Manager in Quantitative Investing from Robeco, recently joined Equilibrium’s quarterly update from Frankfurt. She shared that over the last few years, the rise of passive investing had some market commentators calling it the demise of active investing. This rationale is illustrated in the graph below by Robeco which shows European active fund allocations diminishing over time, as passive investing increased.
The next question is: What has the returns of two different strategies been?
Active versus passive: Underperformance after costs
The table below, an overview of the performance of different markets, shows a significant percentage of active funds underperformed the index over various periods.
The reality is that several global active managers are underperforming after cost. This highlights the need for good manager selection and diversification across the investment strategy to increase the potential for outperformance.
Bargjo noted an increase in the concentration risk in the last decade, driven by the AI frenzy. The chart below illustrates the ‘Magnificent Seven’s’ dominance in the S&P500, which led to higher valuation levels relative to other regions, making the US composite relatively expensive.
As an active manager, this introduced the risk of underperforming the index should you have avoided the dominant and outsized tech shares. It becomes difficult to outperform the market without exposure to these shares. Similarly, passive managers are exposed to a higher risk, due to the disproportionate reliance on the performance of these companies.
Enter trilemma
Another growing theme is the trilemma of solving for return, risk and sustainability, particularly in the growing midst of dissenting sustainability voices. The primary objective of this trilemma or the new efficient frontier is to add return at a reduced risk, while having a positive effect on society or the world.
Bargjo shared with our clients the backlash against sustainable investing, especially, with the new Trump administration. One of the first presidential executive orders was to take the US out of the Paris Climate Agreement. How to win against this backdrop is to remain consistent and follow disciplined, proven investment processes that remain integrated within one’s modelling.
Fundamentals will always adapt to changing environments and it remains prudent to follow an evidence-based approach.
Enter Robeco: The investment engineers
Robeco is a Dutch-based investment world leader with 30 years of pioneering in both systematic and sustainable investing solutions. Robeco believes every strategy should be research and evidence-driven, removing emotion and biases from investing.
Equilibrium selected the Robeco-managed Curate Global Sustainable Equity Fund[1] after a rigorous quantitative and qualitative due diligence process, as one of our underlying global funds.
The inclusion of the fund introduces a low-cost, low-tracking error that follows enhanced indexing strategies in Equilibrium model portfolios. The fund’s objective is to outperform the MSCI World Index, while integrating sustainability in the stock selection. Academic evidence recognises that sustainability integration also leads to improved returns as companies tend to exhibit higher quality traits. This has been evidenced by the actual returns with the fund handsomely outperforming the chosen benchmark.
Enhanced indexing equities: A smarter alternative to passive investing
While passive investing merely tracks an index without making changes, enhanced indexing adds subtle active components without fully abandoning passive principles. These adjustments or systematic tweaks aim to generate higher returns than traditional passive investing over time, while aiming to minimise risk.
The starting position is the index weights, which are then adjusted according to the relative attractiveness. Simplistically, the more attractive constitution would get higher weight while the unattractive ones would get a lower weight.
Some additional benefits of enhanced indexing include:
- Slightly active adjustments for alpha: Small, systematic tweaks to an index or strategy to generate outperformance (alpha).
- Cost efficiency: Keeps costs down by avoiding frequent trading and complex research. This results in lower fees and transaction costs, maintaining more of the portfolio’s returns.
- Flexibility in risk exposure: Offers flexibility by adjusting the portfolio based on market conditions and factors like value or momentum. The ability to exploit inefficiencies and potentially outperform a passive strategy.
- Maintain diversification: Unlike concentrated fundamental strategies, enhanced indexing preserves broad diversification while adjusting portfolio weights. This reduces individual stock risk and captures potential upside missed by passive strategies.
- Reduced tracking error: The strategy closely mirrors the index, offering more consistent performance and a predictable risk profile.
The Curate Global Sustainable Equity Fund, as part of Equilibrium’s portfolios, provides access to Robeco’s superior enhanced indexing strategy, which has benefitted the portfolio since investment through an enhanced return and the added sustainability benefit. Since inception of the mandate, the Robeco-managed Curate Global Sustainable Equity Fund has delivered an outperformance relative to the index of 1.34% annualised.
At Equilibrium, we are constantly looking at our portfolios and our execution options across the markets. We invest across active, passive, systematic and enhanced indexing strategies.
Enhanced indexing strategically adjusts the portfolio by tilting towards specific sectors, factors, or securities while maintaining core alignment with the index. This approach blends the best of passive and active investing, thereby improving long-term returns through a cost-efficient, diversified strategy. It complements fundamental analysis and strikes a balance between the stability of passive investing and the potential for excess returns.
By partnering with Robeco, a fund manager with extensive experience in developing and refining models, Equilibrium offers investors an improved risk-return and cost profile.
In a dynamic market, where new signals constantly emerge, Robeco’s model adapts, ensuring clients’ portfolios remain future-fit.
[1] This fund is eligible for investment by the general public as the Financial Sector Conduct Authority has approved the application for solicitation in South Africa.
Equilibrium Investment Management (Pty) Ltd (Equilibrium) (Reg. No. 2007/018275/07) is an authorised financial services provider (FSP32726) and part of Momentum Group Limited, rated B-BBEE level 1.
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