The theoretical framework

September 30, 2023 marked the 20th anniversary of our Global Research Enhanced Index (REI) strategy. As we pass this milestone, we reflect on the history of the strategy, the wider industry and the future of enhanced indexing.

Enhanced index strategies began in the 1980’s as a hybrid of passive and active investing. The typical enhanced strategy will mimic most characteristics of an underlying benchmark but modify the holdings in a way to try to outperform the index. The use of quantitative (quant) tools in portfolio construction has made enhanced indexing synonymous with quant investing to some, but it is important to differentiate the alpha source from quant tools and techniques used to minimize tracking error. Most enhanced managers use a quant approach to alpha, leaning into certain factors that they believe will be rewarded over time. The problem with this is that even factors that work well over time go through difficult performance periods.

At JPMorgan we believe that idiosyncratic risk, spread out over hundreds of names, can be more consistent if the research platform is robust and the risk management focuses on rewarded risk (stock specific) and minimizes unrewarded risk.

The enhanced index category covers a wide range of risk levels and investment styles, but they typically will have tracking error of less than 2%. Another common trait of enhanced index strategies is that they tend to have more efficient risk management, i.e. higher information ratios, than traditional active strategies. Exhibit 1 plots global equity strategies according to their 5 year tracking error and information ratio. It clearly shows a positive relationship between lower active risk strategies and risk-adjusted returns as measured by information ratio (IR). As this is based on gross of fee data, the relationship would be more extreme after fees since enhanced index strategies typically have much lower fees than traditional, higher risk active strategies.

Why should we care about Information Ratios?

What is the importance of information ratio? Firstly, managers who produce high IRs have a higher probability of outperforming the benchmark over any time period. The chart below illustrates this using standard distributions. In the example, an information ratio of 0.0 means that the manager has no skill and it is essentially a coinflip whether the manager beats the index. But an information ratio of 1.0 implies that it is all but certain (98.73%) the manager will outperform over a 5 year period, and even over 1 year they are likely to outperform 84% of the time.

This is not to say that higher tracking error strategies don’t serve a purpose. In fact, many of the best performing strategies take significant active risk to achieve high excess returns. But higher risk and return also comes with less consistency of return (lower IR) and can take a longer investment horizon to judge manager skill. Lower consistency of return can result in poorly timed terminations. How often have we seen long-term successful managers hired right after a period of strong performance only to underperform and be fired before they can bounce back?

Passive or Enhanced Indexing?

Passive management is often thought of as an economical way to get market exposure, in other words, cheap beta. One advantage is that the risk exposure of a passive investment is likely consistent with the investor’s asset allocation framework and holds few surprises beyond what the market delivers. The primary downside of passive investing is that the net return is likely to trail the index, even with very low management fees. Additionally, stock selection is determined by the index providers and stock weights are determined by market capitalization. This means the better a stock performs, the higher its weight in the index. This can lead to high valuation multiples or stated differently, a bias toward overvalued securities.

Enhanced indexing at its best, has the positive traits of both active and passive investing. It has the ability to identify stocks more likely to outperform, and package those ideas in a portfolio that closely resembles the index from a style, sector and regional perspective. The systematic approach of most enhanced indexing strategies is also additive to returns in that whatever the strategy, price will likely play a part in deciding what to buy and sell. This simply means that when stocks go up, all else equal, you trim positions and when stocks decline, all else equal, you buy. These are marginal decisions that need to take transaction costs in mind, but market volatility makes them additive to returns. Passive index funds do not do this.

The JPMorgan Approach

The strategy’s long-term outperformance is underpinned by the strong partnership between our fundamental research analysts and portfolio managers. Portfolio managers are supported by a network of approximately 80 experienced in-house fundamental research analysts located in North America, Japan, Europe and emerging markets/Asia. Their proprietary company forecasts identify the most likely out/underperforming stocks within their respective sectors and regions. On average, our analysts have 19 years of industry experience, and have been with the firm for 11 years.

Our focus on our strength, stock selection, is very well-illustrated in Exhibit 3. We use the Barra risk model to help manage risk and ensure as much of our tracking error budget as possible is driven by bottom-up fundamental stock insights. It clearly shows that most of our active risk comes from stock selection. The chart is a current snapshot as of June 30, 2024 but has been very consistent over time.

The consistency of our approach to research and the strategy has resulted in remarkably consistent results over two decades. The charts below illustrate the rolling 5-year excess return, tracking error and information ratio of the strategy. The one thing the PM team has most control over is tracking error. That has been the most consistent metric of the 3 over the life of the strategy. You may note it has declined slightly over time, but that also reflects a lower market volatility market in the post-GFC environment. The key consistency has been the focus on our research insights and the minimization of other non-benchmark risks.

Looking ahead

As we look to the next 20 years, we will continue to leverage our proprietary fundamental research but also look to enhance it through new technologies. Powered by Spectrum, our proprietary investment platform, we combine a focus on technology with scale to allow us to harness our large data advantage, built up over 30 years.

Already, our Research Analysts have access to tools that allow them to identify patterns in what company management is saying during earnings calls. They have access to alternative data sources that can add texture to their own fundamental insights. We can analyze past forecasts and learn from mistakes.

Even within trading, JPMAM’s scale and dedication to technology and analytics have materially lowered trading costs while improving execution. Our trading desk has executed over 25 million orders over the last 10 years giving us a proprietary data advantage and execute 10,000 orders per day in 60 global markets. And in REI portfolios, every basis point counts.

Robust risk management continues to be at the core of our process as we continue to leverage technology to strengthen our approach.

In short, these new technological tools will help sharpen our insights, not replace them. We look forward to 20 more years of success in enhancing index returns!