The debate between active and passive investing rages on. Proponents argue each side's superiority, but the issue's never quite resolved. Indexing fits some investors' temperament and strategic approach, while others favor active management. However, there's a third, less-explored option in this debate, combining the best of both worlds: enhanced indexing.
Enhanced indexes track a specific market benchmark but add an element of active management. They aim to beat, rather than match, the index return. If you buy into the concept of indexing, but want your manager to have that little extra bit of flexibility to juice returns, an enhanced index might be right for you.
In this two-part series, we'll take a quick look at some of the best enhanced index funds, as ranked by Morningstar. First up are two funds from Mainstay Investments. They were run by money manager Institutional Capital prior to June 2006, when ICAP sold its business to New York Life Investment Management. The funds were merged into NYLIM's Mainstay fund line, but retained their management team and investment process.
Mainstay ICAP Select Equity (ICSLX)
The Select Equity Fund is run by co-managers Robert Lyon, Jerrold Senser, and Thomas Wenzel. Lyon is the longest-tenured manager, having been with the fund since its December 1997 inception. Senser's tenure goes back to December 2003, while Wenzel is a recent addition, coming on board this past May. This team seeks out large-cap stocks with undervalued short-term growth catalysts, guided by top-down macroeconomic research. The fund's top holdings currently include Textron
The fund's strategy makes it rather concentrated, with only 29 holdings at present. Management is also betting heavily on the industrial materials sector, currently representing 25% of the portfolio. Turnover is also a bit higher here, at 115%, since the managers look only 12 to 18 months ahead in making stock picks. But so far, the fund's layer of active management has worked well. It's beaten the S&P 500 Index in seven of the past nine calendar years, sometimes by a wide margin, which is impressive for an enhanced index fund.
Specifically, Select Equity outperformed the S&P 500 by 18.6% in 2000 and by 12% in 2003, two very different market environments. The fund has posted an annualized 11.9% return from January 1998 through May 2007, versus a 6.6% gain for the S&P 500. All in all, it's a striking track record, making Mainstay ICAP Select Equity Fund one of the top contenders in the enhanced indexing fund category.
Mainstay ICAP International (ICEUX)
The Mainstay ICAP International fund is run by the same management team as its sibling. The investment strategy is also the same, but here, the managers shift their search toward undervalued foreign companies with short-term growth catalysts, such as changes in management or financial restructuring. The fund currently holds top positions in financial-services providers Allianz
Turnover is even higher here, at 155%. ICAP International is also slightly concentrated, currently devoting 25% of portfolio assets to financial-services stocks. Performance has also been impressively solid, although not as eye-popping as the Select Equity fund. ICAP International has beaten the MSCI EAFE Index in six of the last nine calendar years, most widely in 2001, when it outperformed the benchmark by 12.5%. Since its January 1998 inception through May 2007, the fund has returned an annualized 13.3%, compared to 9.2% for the EAFE Index. If you're in search of a foreign enhanced index fund, this may be one of the best picks for your portfolio.
An important disclaimer
While these two Mainstay ICAP funds are both excellent enhanced index funds, they come with a steep minimum. Both funds require a minimum $5 million investment, placing them outside many individual investors' reach. However, if you have your heart set on owning one of these funds but just don't have several million dollars sitting around, there is another option.
Mainstay has recently opened a retail version of each of these funds, Mainstay ICAP Select Equity A (ICSRX) and Mainstay ICAP International A (ICEVX). These funds offer a much more reasonable $1,000 minimum, but also come with a 5.5% front-end load. I don't recommend paying a load fee on any fund, so you should only buy into these retail funds if they're offered through your retirement plan, where loads like these are typically waived. (Just be sure you verify that you're not paying a load before buying in.)
Stay tuned for Part 2 of this series, where we'll look at three more enhanced index fund winners.
Whether you are interested in traditional index funds, enhanced index funds, or actively managed mutual funds, find the funds most likely to make money for your portfolio. A free 30-day trial the Fool's Champion Funds newsletter makes a great first step.