Enhanced Indexing: Risks and Limitations for Investors

Many mutual funds attempt to use enhanced indexing in order to increase the returns that they can generate for shareholders. While this is a nice idea, it does not always work out according to plan. Here are a few of the shortcomings of using enhanced indexing.

Deviating From the Index

The idea behind an index fund is to mimic the returns of an index. This is accomplished by buying all of the stocks that make up a financial index. When a mutual fund company attempts to beat the index, this is referred to as enhanced indexing. In order to do this, they have to deviate from the make up of the index. This requires some form of active management. If the fund manager chooses the wrong stocks to weight the fund, the performance of the fund will suffer.

Higher Costs

Whenever you implement active management strategies, this is going to increase the cost of management. Enhanced index funds are going to have larger expense ratios than mutual funds that are passively managed. This will increase the amount of money that the fund will have to generate in order for you to earn a profit. This makes it even harder to come out ahead with this type of fund.