Question

6. Karen Johnson is responsible for the U.S. equity portion of her company’s pension plan. She is thinking about trying to boost the overall alpha in U.S. equities by using an enhanced index fund to replace her core index fund holding.

A. The U.S. equity portion of the pension plan currently consists of three managers (one index, one value, and one growth) and is expected to produce a target annual alpha of 2.4 percent with a tracking risk of 2.75 percent. By replacing the index manager with an enhanced indexer the target alpha changes to 2.8 percent with a tracking risk of 2.9 percent. Does this change represent an improvement? Why?

B.   Johnson also needs to decide whether she prefers a stock-based or a synthetic enhanced index manager. What are the advantages and disadvantages of each?

Answer 1

A.yes. there is an improvement in the information ratio. which is the ratio of the excess return/systematic risk

enhanced index strategy is using some amount of active risk to beat the index and generate positive alpha.

thus. the index manager has been replaced by the enhanced index manager as a result of which the alpha and increased and the ratio of the alpha to the level of systematic risk has improved.earlier it was 2.4/2.75 = 0.8727

now, with the enhanced index manager the IR ratio now is : 0.9655.

so now the fund is enjoying a higher return with a controlled level of systematic risk involved to earn the excess return.

active risk does no simply replicate the index, but it involves under weighting and over weighting of securities to generate alpha.

b. the enhanced index strategy takes place either at the stock based or synthetic i,e derivatives based.

in the stock based approach: the index manager chooses the stocks on the basis of their expected return . it requires quantitative analysis and research to identify the stocks. and under weights or overweight them in comparison to the index which is called the active management, to generate higher superior returns than the benchmark return. However, the major hurdle is the transaction costs.

advantages :

• it enjoys a large breath i.e the number of stocks for selection is huge.
• as the inefficiency in the market develop the enhanced indexing strategy tends o develop itself.

disadvantages :

• this strategy is more complex in comparison to the synthetic enhanced strategy.
• the fees involved of the enhanced index managers is high.

synthetic enhanced strategy:

this strategy uses derivative contracts which are a combination future's contract ,forwards ,options and swaps and investments in fixed income instruments, to try to generate returns which is higher than the LIBOR. returns greater than the LIBOR is the superior returns.

advantages and disadvantages:

• it is relatively straight forward than the stock based approach.

disadvantages :

• the tracking error is the primary concern with these types of strategies as we try and control the tracking risk . the expected return is also compressed.
• the fees involved of the enhanced index managers is high.