Research adds to active vs passive debate

A new whitepaper published by Insync Funds Management has reviewed the key arguments of the active versus passive investing debate, urging investors to consider several factors before choosing a side.

Author of ‘Is the “Passive versus Active” Argument Flawed?’ and Head of Strategy and Distribution at Insync, Grant Pearson, said the paper helps to debunk the “assumptions and omissions” that have led investors to believe passive funds consistently outperform active strategies.

“[Dangers of assuming passive funds deliver better than active approaches] include that it may rob investors of a better hip pocket result, that it doesn’t properly manage risks and that it undervalues and undermines the worth of professional skill and research,” Pearson said.

He recommends combining two to three active funds with various weightings which can perform better than an index fund.

“This is a valuable layer of skill that impacts the reality for end investors,” he said.

“Excluding this fact infers that such inputs and professionals offer zero value to the outcome. However, the evidence suggests they do add value.

“Rolling Returns’ instead of commonly used ‘point-to-point’ returns provide investors with far more useful assessments of historical returns, as they better account for the average result across all start/end months of the year, thus aligning an investor’s likely return experience. Index promoters and researchers have avoided using this superior measure of returns.

“Two funds can post the same return ‘point-to-point’ yet have very different account balances simply due to the volatility in each. How often, how far and for how long a fund drawdown is, impacts account balances.

“For retirees siphoning off income and capital this is essential knowledge. It’s all in the dollar-based arithmetic, but this can’t be captured at the fund level where marketing is focused. Index funds have no risk or volatility management. Thus, along with the all-important hip-pocket is the cost/benefit of risk management in active investments. Both are crucial considerations.”

Pearson also highlighted the lack of index funds screening out companies with poor stewardship and said this is important to think about when comparing active and passive strategies.

“If you care about good stewardship and basic common values, then this needs to be accounted for in comparisons,” he said.

“Investors do care by and large, but that doesn’t mean they necessarily want ESG focused funds. Governance matters but indexing is devoid of this.

Pearson also said that whole sectors included in index funds can be subject to direct comparisons with managers and their funds that “deliberately” do not invest in most of those sectors, such as emerging markets and resources.

On the other hand, according to Pearson, passive strategies also lack proper consideration of the risk of concentrated investments.

“When a few large-cap stocks dominate an index, the overall index performance becomes highly sensitive to the performance of those stocks. If one or more of these stocks experience significant price declines, the entire index’s performance can be adversely affected,” he said.

“Diversification is key in managing risk. Concentrated indices lack the benefits of diversification, which can help cushion the impact of poor performance from a few individual stocks. Diversified portfolios tend to exhibit lower volatility and more consistent returns.”