Karen Johnson is responsible for the U.S. equity portion of her company’s pension plan. She is thinking about trying to boost the overall alpha in U.S. equities by using an enhanced index fund to replace her core index fund holding.
A. The U.S. equity portion of the pension plan currently consists of three managers (one index, one value, and one growth) and is expected to produce a target annual alpha of 2.4 percent with a tracking risk of 2.75 percent. By replacing the index manager with an enhanced indexer the target alpha changes to 2.8 percent with a tracking risk of 2.9 percent. Does this change represent an improvement? Why?
B. Johnson also needs to decide whether she prefers a stock-based or a synthetic enhanced index manager. What are the advantages and disadvantages of each?