The passive management industry continues to innovate, this time with enhanced index strategies. Wilma de Groot, Head of Core Quant Equity and Quant Portfolio Manager at Robeco, describes enhanced indexing as a proven alternative to passive investing, combining the benefits of this popular style with higher returns and sustainability.

Robeco believes that enhanced index strategies systematically aim for excess returns while efficiently limiting risk. “Like passive strategies, these approaches are predictable, cost-effective, and transparent, but with the additional benefits of potentially delivering higher net returns and better sustainability profiles,” the firm highlights.

According to Robeco’s experience, in recent years, investors have increasingly turned to passive strategies for their core allocations. “While passive investing is popular for its predictability, transparency, and low costs, it has significant limitations, especially in times of high market valuations, geopolitical risks, and growing sustainability demands. This is why today’s investors need strategies for their core allocations that go beyond simply following the market,” Robeco argues.

In this sense, the firm defends enhanced indexing as a smarter alternative, building on the benefits of passive investing while addressing its limitations. “By utilizing proven performance factors, this approach aims to outperform benchmarks, keep costs low, and improve sustainability, all while maintaining risk levels similar to passive strategies. This makes it an attractive option for core equity and credit allocations,” Robeco states in its latest report, *The Smarter Alternative: Enhanced Indexing*.

Passive Investing Has Its Drawbacks

The report questions whether there is a smarter alternative to passive investing, as it also presents some drawbacks. For example, despite its appeal, there are compelling reasons to challenge this approach, especially for core allocations—the foundation of a portfolio designed to produce stable and consistent returns.

“Passive strategies, by nature, lag behind their benchmarks because they incur trading and implementation costs that their benchmarks do not. This can lead to significant underperformance, particularly in less liquid asset classes like credit. Passive investing also ignores decades of academic research on asset valuation, thus missing opportunities to actively exploit market inefficiencies,” the report notes. Additionally, the document highlights “sustainability issues” and the challenge that these strategies are not customizable.

Finally, the report points out another dilemma investors face today: determining where we are in the global equity market cycle and whether U.S. exceptionalism will continue. “Notably, the macroeconomic environment, characterized by high interest rates, growing geopolitical instability, and sustainability concerns, presents challenges for all types of investing. These conditions, combined with high equity market valuations and lofty earnings expectations, could lead to lower future returns,” the report comments.

Based on this analysis, Robeco argues that “a smarter alternative offering better returns with a risk profile similar to the market and greater sustainability than a passive approach can play a key role in core equity allocations, especially if investors need to preserve their risk budgets for alternative satellite investments to meet their overall objectives.”

Advantages of Enhancing Index Strategies

The first argument Robeco’s report presents in favor of enhanced indexing is its potential to deliver better returns. “Unlike passive strategies that blindly follow an index and do not favor one company over another, enhanced indexing strategically invests more in companies with stronger fundamentals while having less exposure to those with weaker fundamentals. Smarter company selection is based on forward-looking performance factors that have been empirically proven to have strong predictive power, allowing the strategy to exploit market inefficiencies to deliver better returns than the index after costs,” the report states.

Secondly, it explains that while seeking improved returns with a risk profile aligned with the index, enhanced index strategies maintain a risk-conscious stance. “Although the portfolio favors companies with stronger fundamentals, this is implemented within measured limits from a portfolio, sector, and company perspective to contain relative risks. Additionally, advanced portfolio construction ensures that the relative risk budget is used efficiently to generate sufficient returns that offset trading and implementation costs, providing returns above the index,” the document adds.

Finally, Robeco emphasizes improved sustainability integration. According to the report, enhanced indexing strategies not only favor healthier companies but also those that are more sustainable. “By definition, passive strategies are indifferent in this regard. And when passive strategies follow ESG-tilted indexes, the risk profile of those indexes can deviate significantly from their core benchmarks, for example, due to differences in sector or regional exposures. This exposes investors to the types of active risks they sought to avoid by choosing a passive strategy in the first place,” the report concludes.