Question

(a). Briefly describe why an investor might consider enhanced indexing, rather than pure indexing.

(b). Briefly describe some of the limitations to cash flow matching as an investment strategy.

Answer 1

a]

Enhanced indexing is an investment strategy where the portfolio assets are indexed to a benchmark, but there is a slight tilt, or under/over weighting towards specific stocks or sectors. While this strategy increases tracking error, the level of tracking error is limited to client preferences. However, this strategy can potentially outperform the index because of the difference in weights.

Thus, an investor may consider enhanced indexing to achieve superior returns over the index while maintaining a portfolio that is mostly passive.

b]

The limitations of a cash flow matching investment strategy are :

• Expensive - It has higher costs because the portfolio has be constantly monitored and rebalanced to match the cash flows
• Complex - Cash flow matching as an investment strategy is complex to implement in practice because the values of the cash flows are constantly changing due to changes in multiple variables