Why You Should Be Wary of Robo-Trading

The investment world is embroiled in a debate between the merits of “passive” and “active” investing. While passive investing has its place, I explain why you should remain an active investor and resist the Siren’s Song of algorithmic trading.

Individual investors who want to profit from the markets but don’t envision themselves as stock-picking wizards are increasingly turning to index funds and exchange traded funds (ETFs) that are largely managed via software algorithms — hence the term passive.

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.

ETFs that track financial indexes have become a major factor for the recent roller-coaster rides in stocks. These funds act as accelerants, up or down. Algorithmic trading will make the next crash worse.

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.

These trends have pummeled the asset-management industry, with passive funds imposing fees that are up to 80% lower than their active counterparts. The industry’s most valuable company is BlackRock (NYSE: BLK), a behemoth in ETFs.

BlackRock, the world’s largest asset manager and issuer of ETFs, currently manages $1.4 trillion in ETFs. And the company is thriving.

On July 16, BLK reported second-quarter 2018 earnings per share of $6.66, versus expectations of $6.55. The company recently moved 50 of its ETFs from NYSE Arca to homes on rival trading exchanges, underscoring the intensifying competition in the ETF realm.

Index funds and ETFs are inexpensive — as well they should be, because they don’t incur the fees and commissions associated with more active trading. Index funds and ETFs charge annual fees that are only a small fraction of those charged by an actively traded fund, because the latter need highly paid “talent” to conduct research and conceive strategy.

The active/passive tug of war…

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 more than nine 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…

It’s during times of uncertainty and turmoil that the active approach can make a big difference.

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-advisor.” 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.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.