Enhanced indexing

The fund’s investments shall in principle reflect the benchmark portfolio’s exposure to the equity, fixed-income and real estate markets. This means that when changes are made to one of the benchmark indices, the fund shall make the same changes. Such a strategy is referred to as indexing. The aim of indexing is to achieve a performance that follows a benchmark. Pure indexing, where a fund seeks to exactly replicate the stock and bond holdings of a benchmark index, is called passive management.

In practice, it’s not always economical to make changes to the fund in exactly the same way or at the same time as changes to the benchmark. Some stocks in the benchmark trade in such small volumes that it would not be cost-effective to buy them on the scale needed by the fund. In addition, several thousand changes to the benchmark stock index are announced each year. Acting on all of these would lead to large transaction costs and the prices would probably be unfavourable because the timing would be known to other market participants. Better prices can often be obtained by buying and selling these securities at other times.

A form of active management

NBIM generally does not use pure indexing to manage the fund, preferring a strategy that seeks to enhance performance and achieve a higher return than the benchmark. Such enhanced indexing is a form of active management.

Enhanced indexing seeks to exploit differences in the value of closely related stocks or bonds. This may mean substituting stocks in the benchmark equity index with related stocks that are more favourably priced. These may be shares in the same company or ownership structure. The fund also takes part in sales where companies in the benchmark offer new stock more cheaply than existing stock, as well as in initial public offerings by companies expected to be included in the benchmark index.  Similarly, the return on the bond portfolio can be enhanced by systematically buying or selling bonds that for limited periods are underpriced or overpriced. Newly issued bonds, for example, often have a higher price than older bonds with a similar maturity.