"Enhanced" Play on Small Caps

10/26/2016 7:00 am EST

Focus: ETFs

John Bonnanzio

, Funds Net Insight

Our latest trade is a rare foray into Fidelity’s “Enhanced” lineup of funds; unlike their typical offerings, Enhanced Index funds have long used Geode Capital Management as their subadvisor, explains John Bonnanzio, editor of Fidelity Monitor & Insight.

In 2001, Geode was formed by Fidelity’s Johnson family and other insiders. Unlike Fidelity’s fundamental (bottom-up) approach to stock picking, Geode’s computer algorithms (not fund managers) drive portfolio construction.

By 2007, hybrids of simple index funds morphed into “smart beta” funds; they are marketed by Fidelity as Enhanced Index funds. The idea is to combine the best attributes of passive (index) and active investing.

Among other qualities, indexing offers lower cost and style consistency, and returns in line with a particular benchmark.

For their part, active funds hold the promise of index-beating returns and Enhanced funds attempt to add a twist on that: superior risk-adjusted performance.

In the parlance of Fidelity, Small Cap Enhanced Index (FCPEX) and its counterparts largely use “computer-aided, quantitative analysis of historical valuation growth, profitability and other factors to select a broadly diversified group of U.S. and foreign stocks.”

Small Cap Enhanced Index has outpaced its Russell 2000 benchmark since the fund’s December 2007 inception — and with roughly 10% less risk.

And, while it has been riskier than Fidelity’s actively run small-cap blend funds, the smart-beta algorithms that drive Small Cap Enhanced Index fund’s returns have provided better returns over the prior 3- and 5-year periods.

While Fidelity’s actively managed small-cap funds offer the potential for outsized gains versus their benchmarks, they can also underperform to a similar degree.

Small Cap Enhanced Index, on the other hand, is unlikely to beat or trail its index by a large margin in any given year, but should outpace it over time. In the current market, we find that attractive.

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By John Bonnanzio, Editor of Fidelity Monitor & Insight

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