Rise of the Machines: Beware of “Robo-Traders”

John Connor: “You don’t feel any emotion about it one way or another?”

The Terminator: “No. I have to stay functional until my mission is complete. Then it doesn’t matter.”

The dialogue comes from the 2003 movie Terminator 3: Rise of the Machines. But that verbal exchange could have come from the trading desk of any large asset manager. Machine trading has conquered Wall Street.

Individual investors who want to profit from the markets but don’t see themselves as stock-picking wizards are opting instead for exchange-traded funds (ETFs) and index funds. These vehicles are managed via software algorithms. Hence the term “passive investing.”

ETFs that track financial indexes have become a major factor for the recent volatility in stocks. These funds act as accelerants, up or down. They could make the next crash worse.

There’s been a proliferation of passive funds that track indices cheaply and others, called “smart beta” investments, that mimic elements of what humans do at far less cost.

Index funds and ETFs charge annual fees that are only a small fraction of what an actively traded fund charges. The latter need highly paid “talent” to conduct research and conceive strategy.

Since 2000, investors have removed $2.5 trillion from active funds and plowed roughly the same amount into passive ones. About two-fifths of the global industry’s equity assets are managed passively, up from nearly zero in 2000, according to research firm Sanford C. Bernstein.

The popularity of passive funds has concentrated financial clout into the hands of BlackRock (NYSE: BLK) and Vanguard. They’re the two biggest providers of ETFs and index funds. Combined, they hold $10.5 trillion in assets and control 65% of the 1,700 ETFs in existence.

Average investors gnash their teeth during huge market swings. The folks at BlackRock and Vanguard impassively gaze at computer screens. There are no portfolio managers yelling market orders. Software programs are doing the work. No human emotions are involved. Machines are in charge.

This transition on Wall Street from human to machine has been unfolding for many years. The following chart shows the distribution of passive and active ETFs worldwide since 2011. It’s projected that by 2020, 31% of global ETFs will be managed passively.

Source: Statista (*projected)

It’s easier to make money with passive funds during a bull market. The true test comes at low tide during a market crash. That’s when investors face a strong temptation to sell, which is usually a mistake. It’s during times of turmoil that the active approach can make a big difference.

As retail investors continue their march toward passive investing, I remain an advocate of active investing.

That sounds like self-interest. After all, I’m an investment strategist. But I still believe that pooled investment vehicles — e.g. mutual funds, ETFs, and closed-end funds — still belong in portfolios.

I don’t want to settle, though, for index performance. At Investing Daily, we strive to beat the market.

To be sure, index funds and ETFs involve less stress. With an index fund or ETF, you’re not tempted to shift your funds from a loser to an ostensible winner. You’re liberated of desperate efforts to buy low and sell high. Emotion is removed from the equation.

The downsides to passive investing? Well, for starters, it’s really boring. But more importantly, your chances of getting rich through the passive approach are just about zilch. And besides, it’s not truly passive. You need to decide which fund is appropriate for your needs and goals; you also need to determine asset allocations.

Also keep in mind, it’s easier to be passive in an up market. This bull market is now about 10 years old and, as they say, a rising tide lifts all boats.

The true test comes at low tide during a market crash, when investors face a strong temptation to sell — which is usually a mistake (and which turns them, ironically, into active managers).

Don’t bury your head in the sand…

There are proactive measures that not only protect your portfolio but also retain a growth trajectory — the sort of informed decisions that I strive to provide in Mind Over Markets. The alternative is to bury your head in the sand.

This overvalued market faces further declines ahead. In previous columns, I’ve recommended that you re-balance your portfolio by paring back exposure to large-cap momentum stocks in favor of value plays. I’ve also recommended that you elevate cash levels and add inflation hedges.

But you can’t expect this sort of balanced and carefully calibrated approach from a passive “robo-trader.” During a market downturn, passive investing results in automatic losses.

Many traders follow the lead of the greatest investors, especially Warren Buffett and his Berkshire Hathaway (NYSE: BRK.A, NYSE: BRK.B).

Buffett once famously said: “Be fearful when others are greedy and greedy when others are fearful.” Does that sound like a “passive” stance to you?

The Key Takeaway: Don’t put your portfolio on automatic pilot. Be sure to perform regular performance reviews of your investments and place performance in the wider context of your long-term policies as well as overall market conditions.

Care to weigh in on the debate between passive and active investing? Send me an email: mailbag@investingdaily.com

John Persinos is the managing editor of Investing Daily.