Fund name: Fidelity Large Cap Value Enhanced Index (FLVEX), Large Cap Core Enhanced Index (FLECX), and Large Cap Growth Enhanced Index (FLEGX)

Objective: Each of the funds seeks capital appreciation by investing at least 80% of its assets into stocks included in the Russell 1000 Value index, the S&P 500 index, and the Russell 1000 Growth index, respectively. The remainder of the money might be invested in a variety of other stuff including foreign stocks, non-index issues and exchange-traded funds.

Adviser: You might think it was Fidelity. No, not quite. It’s advised by Strategic Advisors, which shares an address with Fidelity and which manages $53.5 billion in assets. Each fund is sub-advised by Geode, a Fidelity spin-off which handles quantitative investing for them. Geode manages about $63 billion.

Manager: Jeffrey Adams, Bobe Simon, Patrick Waddell and Fergal Jackson. These folks run index funds for Fidelity, but all have reasonable experience prior to joining Fido. Mr. Adams, for example, spent 14 years at SSgA. Mr. Simon had a decade as a quantitative analyst at Putnam. Messrs. Waddell and Jackson were both quant guys at Fidelity.

Opening date: April 19, 2007.

Minimum investment: $10,000 for both regular and tax-sheltered accounts.

Expense ratio: 0.45%.

Comments: Let me begin with admitting to a certain caustic skepticism when I first encountered Fidelity’s "enhanced index" products. Fidelity pretty much admitted that the funds’ launch was driven by marketing and asset-gathering: "Our research shows that a growing number of investors . . . are interested in the enhanced strategy concept" (VP John Sweeney, news release, 5/1/2007). And it’s hard to warm up to a guy who uses phrases like "the enhanced strategy concept." (Perhaps I should be grateful that he didn’t toss in "metric" or "synergistic" as well.) And the prospectus makes clear that these funds have nothing in common with an "index fund" – not passively managed, doesn’t aim to replicate the index, doesn’t promise low turnover. Which led me to rude thoughts about "natural portfolio enhancement" and its consequences.

On further reading and after considerable effort on the part of one of Fidelity’s spokemen (Alexi Maravel) to track down answers to my questions, I’m much more sanguine about the funds’ prospects.

Enhanced index funds are long-established institutional investments. DFA, for example, classifies 90% of all of their funds as "enhanced indexes." While there are a number of very different strategies available for "enhancing" an index (many of which have . . . uh, limp track records), one of the most common involves using sophisticated computer programs to "tilt" the portfolio so as to overweight the most attractive components of the index. In general, such strategies have a seemingly modest objective: they seek to outperform their underlying index by 100 – 200 basis points per year without imposing risks greater than the index’s. Fidelity’s process proceeds in two steps: finding attractive stocks (through forecasts of valuation, growth, earnings quality, investor sentiment and momentum) and then optimizing risk management in the portfolio as a whole (through some hedging strategies, control of sector weightings and so on).

Fidelity cites some fairly interesting research by Morningstar which compares the performance of index funds, enhanced index funds and actively managed funds. Morningstar looked at the range of excess returns for the three categories; that is, the degree to which they led or trailed the S&P 500. What they found was that, over the past three years, index funds typically trailed the S&P by about 0.7% per year and actively managed funds trailed it by 0.45% per year. Enhanced index funds, on the other hand, outperformed the index by about 0.85% per year. Which is to say, the enhanced index produced about 1.5% more each year than an "vanilla" index and did so without greater risk. And the enhanced index produced about 1.3% better returns than actively managed funds but with substantially less risk. Most of the more or less serious research I’ve looked at (e.g., diBartolomeo, The Enhanced Index Fund as an Alternative to Indexed Equity Management, 2000 and Booth, Index and Enhanced Index Funds, 2001) reaches about the same conclusion. For longer time periods, Fidelity allows that actively managed portfolios might outperform indexed ones but would mostly achieve modestly higher returns with substantially higher risks.

Are there reasons to hesitate? The primary one is that Geode’s particular system has no public track record and so we can’t assess the quality of their work. When I raised this issue with Fidelity spokeman Alexi Maravel, here’s how he responded: "While these strategies have been piloted for several years, I cannot elaborate pilot (internal) portfolio performance. Like any investment thesis, we test the strategy rigorously before we make it available to the public."

Bottom line: Were I an investor in one of Fidelity’s other quant funds, I’d likely be annoyed to be paying twice as much in expenses as these quant funds would charge. Beyond that, investors who are tempted to index the core (or, in some cases, the vast bulk) of their equity portfolios might want to stop and check out the prospects here. Likewise, those dissatisfied with the mediocrity of many of Fidelity’s actively-managed large cap funds. Despite the uncertainties, enhanced indexes offer the prospect of modest net gains with little countervailing pain.