Insync uncovers flaws in passive versus active debate

Insync Funds Management says the industry has taken at face value the argument that passive outperforms active, but a deeper dive indicates this is not necessarily so.

Wednesday, October 18th 2023, 6:00AM

by Insync

Insync Head of Strategy and Distribution, Grant Pearson, has written a White Paper which gives seven key factors in portfolio construction that demand full consideration before assuming the powerful marketing messages from index managers are relevant or correct.

1. Blending 2-3 active funds often does better than an index fund
If devised properly by trained professionals, two to three active funds blended often do better than an index fund. Most investors using active managed funds tend to use a composite of them with various weightings that also shift over time. Intermediated inputs of some form are present in a very large portion of all active funds under management (FUM), be it model portfolios or forms of advised recommendations.

"This is a valuable layer of skill that impacts the reality for end investors," Pearson says. "Excluding this fact infers that such inputs and professionals offer zero value to the outcome. However, the evidence suggests they do add value."

2. Applying meaningful time-based measurements
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," Pearson says.

3. Challenging the over-simplification of index comparisons
Using almost any month of ‘point-to-point’ returns, a cohort of 10-20% of active funds usually outperforms the relevant index fund.

"This is especially so outside extreme frothy markets," Pearson says.

4. Measure active returns, risk adjusted and in the hip-pocket
Active management is only accurately calculated at the investor’s dollar account level, not at the fund level because risk and volatility management are provided with active management, and this alters the dollar-based account balance.

"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," Pearson says.

"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."

5. Index comparisons rarely exclude companies with poor stewardship
Most active funds including non-ESG offers do have standards on this to various degrees.

"If you care about good stewardship and basic common values, then this needs to be accounted for in comparisons," Pearson 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."

6. Poor index benchmark selection
Whole sectors of an index’s return are often pitted against a manager whose fund deliberately doesn’t invest in most of it (eg: emerging markets and resources). An active mega cap global equity manager is often compared to an entire index (usually the MSCI-AWI) that’s mostly comprised of non-large cap stocks and also in countries they wouldn’t ever invest in.

"One has to ask if this is even appropriate?"

7. The downsides of ‘dominated concentration’
The risk of concentrated investments, particularly in specific sectors or narrow asset classes, may not be adequately addressed by passive strategies. 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.

"Diversification is key in managing risk," Pearson said. "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."

Pearson said the Paper uncovers some of the dangers of assuming passive funds deliver better than active approaches, which 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.

"Passive investment has a place but to nowhere near the extent it is currently being used in our industry, which is relying upon incorrect assumptions and omissions. We owe it to the end investor to look harder."

CLICK HERE for the Insync White Paper

Established in July 2009 by Monik Kotecha and Garry Wyatt, Insync Funds Management Pty Ltd (Insync) is a core global equities manager based in Sydney with Equity Trustees as its RE. A high conviction, bottom-up, quality style manager, Insync employs a valuation-based approach, selecting stocks from a concentrated group of global large cap companies. These stocks must meet Insync’s rigorous filters, benchmarks and hurdles, and be beneficiaries of one or more of 16 global megatrends that Insync has identified are key predictors of growth. They must also consistently allocate capital efficiently, and have a high Return on Investment Capital (ROIC). For more info see https://www.insyncfm.com.au/

Tags: Active v Passive Insync Funds Management