A Compelling Middle Ground: The Enhanced Equity Advantage

Investors are increasingly interested in enhanced equity, i.e., active strategies that take low active risk, with tracking error (TE) typically in the 1-2% range. Enhanced strategies closely track an index and strive to outperform it. Compared to traditional active strategies, they seek more consistent outperformance and smaller drawdowns at the cost of a more modest expected return target. Many allocators will find this tradeoff a good match for their investing objectives.

Enhanced equity is not a new concept. Twenty-five years ago, Ronald Kahn advocated that such strategies “should receive the largest allocations of capital from most pension plans” (Kahn, 2000). This advice has gone largely unheeded. Instead, many investors have gravitated towards a combination of two extremes—a sizable passive allocation coupled with high-active-risk, concentrated equity portfolios. Whatever the reason for the past underappreciation of enhanced equity—perhaps its benefits were poorly understood or discussions involving modest return targets did not spark broad enthusiasm—we are receiving more inquiries about it now from a broad range of allocators. In this overview, therefore, we explain its appeal.¹

Enhanced as a Middle Ground

To motivate the discussion, Table 1 compares enhanced strategies, passive allocations, and traditional active strategies with respect to several attributes, including risk and return potential, costs, and ease of implementation. Across these dimensions, enhanced equity raises no obvious red flags. Its balanced nature between passive and traditional active should appeal to many investors. There also is one area in which enhanced positively stands out, consistency of active performance.

Table 1: Pros and Cons of Enhanced Equity Versus Passive and Traditional Active

Over the next two sections, we highlight enhanced strategies’ benefits and present intuition to explain their sources. We frame this discussion from the perspectives of two audiences that should take special note of enhanced strategies, “avoiders” and "seekers." By avoiders, we mean allocators who are currently invested in traditional active strategies but who are facing cost pressures, governance scrutiny, or concerns around reliability of performance. By seekers, we mean allocators who are currently invested in passive but who need a boost in returns to meet performance targets or who need a more customized portfolio than they can find among available passive vehicles. 

For Avoiders: Higher Risk-Adjusted Returns, Less Drama

Traditional active strategies can experience prolonged periods of material underperformance due to their high active risk budgets. Moreover, even when such strategies are performing well, ongoing monitoring requirements may challenge an allocator’s governance structure. The more concentrated the portfolio and the higher the active risk, the greater these challenges become.²

Enhanced equity shines in comparison. It is tightly risk-controlled, so that when executed correctly its total returns will largely reflect the underlying benchmark’s performance. Therefore, enhanced strategies are unlikely to suffer deep and prolonged drawdowns versus their benchmarks. While investors should not expect enhanced equity to deliver the same level of benchmark-relative returns targeted by traditional active strategies, the more modest active return expectation comes with meaningfully lower tracking error and a higher expected active risk-return tradeoff (i.e., information ratio, or IR).

Figure 1 presents empirical evidence consistent with this assertion. Focusing on a sample of strategies benchmarked to global indexes from eVestment,³ The table groups strategies into three tiers based on realized active risk, Enhanced (TE ≤2% per annum), Traditional Active (2-6% TE), and High TE (≥6%), and it plots the average IR for each category. We present results over the past two decades, 2015-2024 and 2005-2014.⁴

Figure 1: Average Information Ratios by Level of Active Risk—Global Active Equity Strategies

The chart not only confirms that low-TE strategies have generated more consistent performance, but it also helps us understand why these strategies are becoming more popular now. Over the last 10 years, the average traditional active strategy underperformed its benchmark, while enhanced strategies delivered positive active returns.

SOURCES OF HIGHER RISK ADJUSTED RETURNS

There is an intuitive explanation for the attractive risk-return tradeoff of enhanced strategies: the tight control on tracking error leads to a purer (though more modest) expression of an active manager’s skill. To understand why, we compare a traditional systematic active and an enhanced strategy that are both built around the same investment view. That is, each strategy maximizes alpha based on the same return and risk forecasts; the only difference is in their tracking error budgets. We expect the enhanced strategy to have a higher risk-adjusted return for three principal reasons.

1) Better transfer of negative views into the portfolio

By construction, the traditional active strategy will seek larger overweights compared to the enhanced strategy, which—in a long-only context—must be “funded” by correspondingly large underweights across the portfolio. However, most benchmark stocks cannot be materially underweighted, since even the median stock in a typical market index only has a one to two basis-point weight. So, to fund its relatively large overweights, a traditional active manager may need to underweight (or just not hold) more and more stocks, gradually moving from very negative to mildly negative alphas, or perhaps even to stocks on which the firm has a neutral view. The more concentrated the strategy, the more acute the issue becomes: a manager that only holds 20 benchmark stocks cannot differentiate the views that it expresses on the hundreds (or even thousands) of the remaining stocks in the benchmark – all these stocks end up with maximum underweights. Moreover, the need to fund overweights often causes traditional active managers to meaningfully underweight the largest benchmark constituents. For example, in recent years many active managers blamed poor performance on underweighting the Magnificent 7 to source overweights elsewhere in the portfolio.⁵ In contrast, an enhanced strategy has smaller active funding needs, so it may be able to hold neutral stocks at roughly benchmark weight, partially underweight stocks with mildly negative alphas, and divest completely only stocks with the most negative investment views.

2) Improved control of macro risk

The larger a manager’s desired overweights, the more likely it is that some unwanted risks will sneak into the resulting portfolio. To illustrate, consider a manager with a highly positive forecast on Novo Nordisk, the Danish healthcare company, which had a 0.3% weight in MSCI ACWI as of March 31, 2025. Even if the portfolio had zero exposure to all other Danish stocks, the moment the Novo Nordisk overweight exceeds 0.2%, the manager would be overweight the Danish country and currency, since Denmark’s overall index weight is about 0.5%. Even without any view on Denmark or the Danish Krone, the manager would be unable to avoid active risk from these sources if it took a larger position in the company. Since an enhanced strategy would take smaller overweights, it should incur smaller unintended macro exposures.

3) Prioritization of distinctive investment insights

Risk and return both matter for portfolio construction. Even a stock with a high return forecast may not be a good candidate for an overweight if that positioning would consume too much of the overall risk budget. For a long-only strategy, one implication of the tight tracking error budget is that portfolio construction cannot take much undiversifiable risk in maximizing alpha. As a result, enhanced strategies naturally skew towards alpha derived from (distinctive) idiosyncratic stock selection rather than from more commonplace sources associated with exposure to systemic risk, including countries and industries but also generic versions of factors like value and momentum.⁶ As the tracking error budget is loosened, alpha maximization is likely to be supported by taking more risk that is undiversifiable. All three of the above benefits arise because enhanced strategies are incentivized to take many small active positions, with less interference from the long-only constraint. This leads to purer exposure to a manager’s insights and better diversification.

BETTER DRAWDOWN BEHAVIOR

All active strategies can (and will) have periods of underperformance. This is a problem not only due to the erosion of asset owners’ capital, but also because extreme performance may induce poor decision making.⁷ From that perspective, enhanced strategies are less of a governance burden. Their drawdowns are likely to be less frequent for the reasons outlined above, less severe due to the lower active risk target, and less likely to coincide with whatever may lead the news on a given day. In other words, enhanced equity’s risk profile makes the strategy “a good kind of boring.” The lack of drama can increase an asset owner’s staying power and ultimately lead to a higher long-term return than if the asset owner invested in—but gave up on—a very attractive strategy that has a higher active risk profile.

For Seekers: Index Outperformance and Customizability

As Table 1 makes clear, passive equity is enticing because it is simple, cheap, and easy to monitor. But passive also has the downside that its expected return cannot be (much) higher than that of the index it tracks, even if some vehicles seek to at least partly offset drag from implementation costs and fees by passing through securities lending revenue or via dividend withholding tax management. For allocators seeking a performance boost relative to their benchmarks, enhanced strategies offer a better alternative.

Why would we expect enhanced strategies to outperform passive? The main reason is portfolio manager skill. For the reasons already explained, a skillful manager with a low active risk budget should be able to generate modest and consistent excess returns. But there is another, less-apparent reason.

The indexes that passive vehicles track often rebalance to rigid schedules based on mechanical rules. The predictability presents a potential source of drag on performance of the indexes themselves and execution risk for the passive products that slavishly track them, because informed market participants can and do trade ahead of the passive funds (e.g., buying securities that will be added to the index and selling those that will be deleted).⁸ Enhanced managers can naturally ameliorate such risks by keeping their trading programs confidential, by incorporating transaction cost estimates into portfolio construction, and through fundamental and technical signals embedded in their stock return forecasts.

Moreover, the composition of many popular benchmarks is subject to discretionary oversight, which calls into question just how “passive” those indexes really are.⁹ The S&P 500 first comes to mind, with a committee that governs not only choices over constituents but also over the timing and process of index changes.¹⁰ But MSCI and FTSE/Russell also make discretionary calls, for example regarding whether countries should be classified as emerging or developed and how various classes of stocks should be weighted.¹¹

Finally, investors who need to customize their portfolios have additional reason to consider enhanced strategies instead of passive. While there are literally millions of indexes available from a variety of providers ("there’s an index for that”), there still may not be a precise match for an asset owner’s specific needs. Moreover, custom index construction often requires judgment, meaning that the resulting portfolios are no longer “passive” in any meaningful sense. By comparison, an explicitly active solution offered through a customized enhanced strategy can offer an appealing alternative. 

Conclusion

Historically underutilized, enhanced equity offers a compelling middle ground between passive indexing and traditional active management. In seeking to deliver modest but consistent excess returns with controlled active risk, enhanced equity strategies should appeal to both investors who are stepping away from traditional active strategies due to risk, cost, or governance considerations and to passive investors who are under pressure to beat their benchmarks. 

In contrast, the popular “barbell” approach of pairing large passive allocations with a few high-conviction bets is more complex, as it requires navigating two polar-opposite types of investing approaches. This approach may have a place, particularly where true manager skill is more evident or where market inefficiencies are more pronounced. But for many asset owners and use cases, enhanced equity may offer a practical and appealing solution.

Appendix: eVestment Dataset for Figure 1

Dataset includes long-only strategies from eVestment’s Global All Cap Equity, Global Large Cap Equity, and Global Enhanced Equity universes with the following exclusions:

• Low-volatility, sector/industry-focused, dividend/income focused, options-focused, and thematic strategies.
• Strategies that have preferred benchmarks from an unknown index provider or blended benchmarks.
• Strategies that did not survive the full decade over which tracking error and active returns are calculated.
• Strategies with tracking error over the relevant decade that was < 0.5% or > 10%. Returns are net of fees and in USD.

References

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Harvey, Campbell R., Michele Mazzoleni, and Alessandro Melone, “The Unintended Consequences of Rebalancing,” Working paper, 2025.

Kahn, Ronald, “Most Pension Plans Need More Enhanced Indexing,” ETFs and Indexing (2000): 65-71.

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