The world of investments is never static; it continuously evolves under the influence of market dynamics, policy shifts, and investor sentiments. In recent years, particularly over the last two, the pursuit of outperforming indices has become a daunting challenge for many investors, especially with the underwhelming performances of numerous actively managed equity funds. Indeed, many of these funds have found themselves eclipsed by broad market indices, prompting a growing interest in enhanced index funds—investments strategically positioned to not just mirror indices but to exceed them.

According to data from Wind, the enhanced index funds have been successfully generating considerable excess returns this year. By the end of May, notable funds like the Chuangjin Hexin Northern Fortune 50 Enhanced Index Fund A and the E Fund’s CSI 300 Selected Enhanced Index Fund A boasted excess returns of over ten percentage points. In instances where broader indices, such as the CSI 1000 and CSI 500, faced declines, enhanced index funds managed to defy the downward trend, securing positive returns and demonstrating significant excess yield.

The performance of these funds has fostered a burgeoning recognition of their investment value among capital sources. Industry insiders reveal that since the beginning of the year, many fund advisors have begun integrating enhanced index funds into their portfolios, with institutional investors increasingly viewing such funds as critical tools for long-term asset allocation.

Enhanced index funds operate on a unique premise: while they passively track the performance of a given index, they utilize active stock selection and sophisticated quantitative models to reconfigure their portfolios in pursuit of outperformance relative to the benchmark index. Notably, Wind's statistics showed that as of May 28, 276 enhanced index funds were available in the market, 201 of which outperformed their performance benchmarks. This signifies that over seventy percent of these funds have successfully generated excess returns.

Among the standout performers, four enhanced index funds achieved excess returns surpassing ten percentage points, led by Chuangjin Hexin's Northern Fortune 50 Enhanced Index Fund A with an impressive 13.84% excess return. Such notable figures underline the effectiveness of these funds, particularly at a time when traditional indices face downward pressures.

The ability of enhanced index funds to rally against a backdrop of declining indices is evident in practical examples. For instance, the CSI 1000 index faced a decline of 9.16% this year, yet the Bank of China’s CSI 1000 Enhanced Index Fund posted a notable increase of 4.89%, outperforming its benchmark by about fourteen percentage points. Similarly, while the CSI 500 index saw a drop of 2.08%, numerous products tracking this index—such as the Postal Savings Bank's CSI 500 Enhanced Index Fund—achieved solid performance, with some funds rising by as much as 6.53%. This exemplifies a decisive capacity to generate returns, even in adverse market conditions.

The exceptional performance of enhanced index funds this year can be attributed to various factors. Wang Ying, a quantitative fund manager at CITIC Prudential, notes that these products are regulated at the contractual level, enforcing a restriction that mandates at least 80% of the fund’s non-cash assets be invested in the underlying index constituents and their selected alternatives. This strategic approach enables these funds to experience smaller drawdowns than the underlying indices during market declines, while their quantitative strategies often deliver superior returns during market rebounds.

Taking cognizance of their impressive track record, the enhanced index fund sector is currently experiencing a surge in issuance. Numerous fund companies are committing to new strategies, which further underscores the evolving landscape of index funds. Just in the month of May alone, five new enhanced index funds were launched, marking a significant increase both year-on-year and month-on-month.

On May 29, CITIC Prudential unveiled its CSI 500 Enhanced Index Fund following the successful launch of its CSI 300 Enhanced Index Fund late last year. The rationale behind focusing on the CSI 500 lies in the considerable transformations that have occurred in this index over recent years, meriting renewed attention from investors.

Firstly, the market capitalization structure of the CSI 500 has evolved. Historically characterized as a benchmark associated with small- and mid-cap stocks, the CSI 500 has grown to include a greater proportion of mid- to large-cap stocks. By the end of 2023, the average market cap of constituent stocks in this index reached approximately 23.9 billion, meaning that less than 12% of A-share listed companies surpass its average market cap. Secondly, the industry composition has also undergone significant shifts. In the past decade, the previous top five sectors represented in the CSI 500 have transitioned from medicine, real estate, and chemicals to a more diversified mix, increasingly aligning with the drive for new productive capacities.

Given these developments, the CSI 500 no longer exclusively piques the interest of quantitative investment circles; institutional ownership has steadily risen in the last ten years, and with policies encouraging improved quality among listed companies, such factors favor a capital return flow towards mid- and large-cap companies, creating a favorable environment for the CSI 500.

In addition to corporate strategies, CITIC Prudential has also recently obtained approval for one of the industry’s pioneering enhanced index funds focusing on the Sci-Tech Innovation Board. Meanwhile, Pulley Jin An Insurance has similarly initiated its own round of enhanced index fund launches, adding depth to this burgeoning class of financial products.

Sun Chenjin, the head of the index and quantitative investment division at Pulley Jin An, highlighted the firm’s strategy orientation towards broad-based enhanced index funds and sector-specific strategies in response to current market needs and innovation demands. The competition in broad-based products is notably fierce, with leading fund companies capturing a substantial share of the market in terms of size and liquidity. By venturing into innovative product offerings, emerging fund managers aim to achieve differentiation, adequately addressing specific investor demands and strengthening their market positions.

However, the enhanced index fund landscape is not without its challenges. Over the past two years, fluctuating market conditions have complicated management strategies for these funds. Many fund managers have openly discussed the necessity to upgrade and optimize their quantitative strategies amid these ongoing market complexities.

For example, at the beginning of the year, with significant market downturns, many enhanced index funds experienced steeper corrections than their respective indices. Wang Ying identified a primary reason: the sources of returns in volume and price strategies often hinge on the short-term inefficiencies within stock prices, favoring stocks with lower liquidity, ultimately making them more susceptible to market shocks.

Consequently, in creating new investment products, there's a heightened emphasis on strict constraints regarding risk exposure. Wang’s fundamental model is anchored in a multi-factor framework centered on the fundamentals, ensuring neutrality relative to the CSI 500 index, while additional models blend various strategies such as volume-price tactics, event-driven, and negative strategies to manage risk exposure effectively.

Wang’s holistic approach employs three-tiered risk control measures aimed at minimizing drawdowns associated with pursuing excess returns, addressing issues at the factor level, sub-strategy level, and product level. At the factor level, she prioritizes controlling the weights and exposures of individual risk factors, adjusting for high volatility. Conversely, at both the sub-strategy and product levels, she regulates the proportions of single-substrates and sector deviations, demonstrating an intricate understanding of risk management across multiple dimensions.

Moreover, certain quantitative fund managers suggest that their newly upgraded strategies now harmoniously blend bottom-up and top-down selection methodologies, creating a balanced, complementary approach to index enhancement. This dual approach underscores the importance of macroeconomic research in gauging the relevance of different factors, a crucial element influencing individual stock scoring.