Indexers Do the Active Twist to Beat Market

In baseball, a batter who averages one more hit each week than his teammates is an all-star.

In track, a sprinter who stays one-tenth of a second ahead of the field is a champion.

And in mutual funds, a portfolio manager who consistently beats the market by 1 percentage point a year is a legend.

It’s no easy feat matching the market, let alone beating it. Only 31 stock-oriented funds have topped the performance of the Standard & Poor’s 500 index over the past decade and a half, according to fund tracker Lipper Inc. of New York. Just 17 beat the index by at least 1 percentage point annually over the 15-year span ending March 31.

That’s 17 out of 414 stock funds that have been around at least 15 years, not counting dozens of poor performers that were merged into other funds or liquidated over the years. To be fair, the S&P; 500 has outperformed other indexes in this period, and active managers had a better record before the 1990s bull market.

But the track record makes index funds popular, so some companies have decided to add a managed twist to indexing to enhance performance.

Some make use of quantitative or computer-driven models to pick stocks within the S&P; 500 or some other index that appears more promising than the rest. The Vanguard Group in Valley Forge, Pa., has five funds partly or fully managed in this manner, including Vanguard Growth & Income and Vanguard Horizon Aggressive Growth.

If this sounds a lot like active management, that’s because it is. “But there is a difference in degrees that separates us from traditional active managers,” said Gus Sauter, who oversees Vanguard’s quantitative funds along with the company’s other index portfolios.

“While they think they can find stocks worth $40 that are selling for $25, we merely believe we can locate stocks worth $40 that sell for $38.”

And there are other quantitative strategies that strive to beat the S&P; 500. For example, Numeric Investors in Cambridge, Mass., aims to identify mispriced stocks while also tracking analyst profit forecasts. The assumption is that professional stock watchers tend to raise or lower their estimates in stages that are predictable.

Analysts are “initially cautious with their earnings estimates, then raise the numbers in small steps in the same direction.” said Arup Datta, who runs three Numeric funds. Meanwhile, the new BT Quantitative Equity Fund is striving to beat the index by taking big bets in S&P; 500 companies engaged in mergers or acquisitions. The New York company aims to exploit the modest arbitrage opportunities that often accompany large Wall Street deals.

There are other variations on index funds, including funds that intentionally magnify the performance of the index with the use of futures, such as Rydex Nova.

Perhaps the most interesting approach is one whereby fund managers hope to beat the S&P; 500 by investing in bonds.

They frequently start by purchasing futures contracts on the S&P; 500. The values of these contracts rise and fall in nearly perfect lock-step with the index, yet a futures position can control a large index position for very little cash down, along with a financing charge. That frees up most of a fund’s assets to be invested in something else--usually bonds.

If the managers can buy bonds whose yields more than offset the fund’s various expenses--including that futures financing charge--then shareholders will beat the S&P; 500.

The Pimco StocksPlus Fund, based in Newport Beach, is a standard-bearer for this bond strategy. Its institutional shares outperformed the S&P; 500 by an average of eight-tenths of a percentage point annually over the five years ending April 30, reports fund tracker Morningstar Inc., although the S&P; 500 has enjoyed an edge more recently. More important, the index has beaten Pimco’s higher-cost retail shares, underscoring the importance that expenses exert on performance.

Then there’s the Smith Breeden U.S. Equity Market Plus Fund in Chapel Hill, N.C., which achieved a razor-thin performance edge over the S&P; 500 during the past five years. It too pursues a bond-oriented enhancement strategy. So does another rival, the Los Angeles-based Payden & Rygel Market Return Fund, but this portfolio hasn’t quite kept up with the index.

Mindful of the drag that high expenses can exert, the new Metropolitan West AlphaTrak 500 Fund couples a bond-enhancement strategy with performance-based fees. If the fund handily beats the S&P; 500, investors will pay up to 0.9% a year; if the fund badly lags, they pay only 0.2%.

“If we don’t outperform the 500 index, we essentially don’t get paid,” said Stephen Kane, managing director of the Los Angeles fund.

As a group, the bond-oriented funds are faring reasonably well. The AlphaTrak portfolio is off to a particularly strong start, having beaten the S&P; 500 by about 3 percentage points since its inception last June.

However, these enhanced bond portfolios face risks that make them hard to compare in the same breath with the quantitative funds. In particular, the futures and bonds could perform worse than anticipated.

Most enhanced index funds are best suited for tax-deferred accounts, because these funds are more likely to incur capital gains taxes with more-frequent trading.

It’s also important to emphasize that no enhanced strategy will provide much protection if the S&P; 500 takes a nose dive. Remember, the intent is merely to beat the market by perhaps 1 percentage point a year, not to sidestep downdrafts. “If the S&P; 500 goes down 20%, our goal would be to drop only 19% or so,” Kane said.

Given the greater complexities, tax drawbacks and higher expenses of enhanced funds--to say nothing of the lack of downside protection--you may conclude that a straight index portfolio makes more sense.

“With these enhancements, we try to outperform the market, but there are no guarantees,” Vanguard’s Sauter said. “The odds are about 3-to-1 against us.”

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Russ Wiles is a regular contributor to The Times and co-author of “How Mutual Funds Work,” published by Simon & Schuster. He can be reached at russ.wiles@pni.com.

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S&P; 500 Index Funds

Below are five of the biggest index funds that track the Standard & Poor’s 500 index of blue-chip stocks. In general, the lower the expenses, the higher the fund’s total returns.

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1-year 3-year 800 total annualized Expense phone Fund name return* return ratio number Vanguard Index 500 21.5% 27.2% 0.18% 662-7447 USAA S&P; 500 21.4 27.2 0.18 382-8722 Fidelity Spartan Market Index 21.4 27.0 0.19 544-8888 T. Rowe Price Equity Index 500 21.2 26.9 0.40 638-5660 SSgA S&P; 500 Index 21.3 26.9 0.42** 647-7327 S&P; 500 Index 21.5 27.4

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** Includes expense ratio and 12b-1 fees.

Enhanced Index Funds

Some funds track the major stock market indexes, but add a twist of active management in hopes of “enhancing” performance. Below are five well-known examples of such funds. As you can see, not all “enhanced” index funds enhance the returns of the indexes.

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1-year 3-year 800 total annualized Expense phone Fund name return* return ratio number Rydex Nova 23.1% 32.4% 1.11% 820-0888 Pimco StocksPlus Inst. 21.0 26.9 0.65 927-4648 Smith Breeden 20.3 26.7 0.88 221-3138 U.S. Equity Market Plus Vanguard Growth & Income 18.6 26.6 0.36 662-7447 Payden & Rygel Mkt. Return 19.5 26.2 0.45 572-9336 S&P; 500 Index 21.5 27.4

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*Total return figures through May 21.

Source: Morningstar