Active Index Fund

What Is an Active Index Fund?

An active index fund is a basket of assets in which the fund manager constructs the initial investment with holdings from a benchmark index and then adds securities unrelated to the underlying index or removes existing index components with the goal of driving portfolio performance higher. This additional layer of non-benchmark securities aims to boost returns above a traditional buy and hold passive strategy by allowing for some active management.

By adding individual stocks disconnected from the broader index, the fund manager can unlock additional alpha. Active index funds may employ a tilt or use a smart beta strategy.

Understanding Active Index Funds

An active index fund attempts to take a version of an index fund like the Standard & Poor's 500 Index (S&P 500) and periodically rebalance all the stocks to match the proportions found in the actual S&P 500. The manager will add stocks to the fund they believe will yield additional returns to the passive index fund. For example, if the manager believes semiconductors will produce strong results for future quarters, more semiconductor stocks would be added to the portfolio.

While it is possible for some fund managers to significantly beat the underlying benchmark index by using strategies like market timing, this is far from guaranteed. Passive funds can be counted on to follow an index faithfully, which allows investors to know the true holdings and risk profile of the fund. This helps investors keep a diversified portfolio and managed expectations.

Adding an active layer to the index fund makes it difficult for the investing community to anticipate the future makeup of the fund. This can work for investors when the market experiences heavy volatility and the fund requires a trained professional to limit drawdowns. A fund manager can shift allocations away from underperforming positions to more appropriate sectors or asset classes. However, most empirical research finds a simple passive strategy tends to outperform a complicated active management approach.

Tilt Funds

A tilt fund is a type of mutual fund or exchange-traded fund that includes a core holding of stocks that mimic a benchmark-type index, to which additional securities are added to help tilt the fund toward outperforming the market. Sometimes called enhanced index funds, these are active index funds used by major investors in an effort to improve overall investment returns.

A fund that utilizes a tilting strategy might have the vast majority of capital invested in those 500 companies, but it might also allow the manager the flexibility to include other stocks as well. On the other hand, value tilts in a fund may also lean toward one type of stock over another, such as leaning toward small-cap stocks that historically have provided higher-than-average returns. 

Smart Beta

Smart beta strategies seek to passively follow indices, while also considering alternative weighting schemes such as volatility, liquidity, quality, value, size, and momentum. That's because smart beta strategies are implemented like typical index strategies in that the index rules are set and transparent. These funds don’t track standard indices, such as the S&P 500 or the Nasdaq 100 Index, but instead, focus on areas of the market that offer an opportunity for exploitation.

There is no single approach to smart beta, as the goals for investors can be different based on their needs, though some managers are prescriptive in identifying smart beta ideas that are value-creating and economically intuitive. Equity smart beta seeks to address inefficiencies created by market-capitalization-weighted benchmarks. Funds may take a thematic approach to manage this risk by focusing on mispricing created by investors seeking short-term gains, for example.

Limitations of Active Index Funds

Although an active index fund holds many of the same securities of a traditional index fund, they tend to come at a premium. Taking an active management style means the fund must charge higher fees to cover the cost of the manager, research materials, and any other data required to make thoughtful investment decisions.

These higher expense ratios put pressure on fund managers to consistently outperform or beat the underlying index. As with a mutual fund, the potential to outperform comes down to the manager. Some have a knack for finding hidden gems, but most will pick losing assets that limit potential performance of the fund.