The Rise Of Robots & The Risk To Passive

Tyler Durden's picture

Authored by Lance Roberts via RealInvestmentAdvice.com,

In Tuesday’s post, “A Shot Across The Bow,” I discussed the recent “Tech Wreck” and the warning sign that was delivered when trading algorithms begin to run in the same direction. To wit:

 “The plunge was extremely sharp but fortunately regained composure and shares rebounded. A ‘flash crash.’

 

One day, we will not be so lucky. But the point I want to highlight here is this is an example of the ‘price vacuum’ that can occur when computers lose control. I can not stress this enough.

 

This is THE REASON why the next major crash will be worse than the last.”

Of course, it generally isn’t long after publishing commentary about the dangers of the current crowding into ETF’s, that I receive some push back.

First, I am not a “broker.” I am a “fee-only” investment advisor which operates under the “fiduciary standard.” While we do charge a below average fee for our services, our focus is on capital preservation and total portfolio returns to achieve our client’s long-term financial planning goals. Our client, and most importantly their hard earned savings, are our priority. (Read more in “The Financial Manifesto.”)

Secondly, I find a consistent uniformity of those who have fallen victim to the “buy and hold” and “passive indexing” mantra such as:

Lastly, these individuals are NOT “passive” investors. They are simply “passive holders” while markets are rising and will become “active sellers” during the next significant decline. 

However, let me clear, I am certainly NOT against using “indexed based” ETF’s for managing exposure to the markets for individuals who wish to have:

  1. Lower trading costs
  2. Higher tax efficiencies
  3. Less turnover
  4. Lower volatility
  5. Access to asset classes not covered in a traditional equity portfolio

But gaining access to those benefits does NOT mean being oblivious to the underlying risk of ownership. The firm I manage money for runs both an all-ETF strategy, as well as a blended ETF/Equity portfolio, we also apply a very strict set investment rules toward the management of “risk” in the portfolio. In other words, the entire practice adheres to Warren Buffet’s primary rules on investing:

  1. Don’t Lose Money
  2. Refer To Rule No. 1.

As is always the case, the time spent making up lost capital is far more detrimental to the long-term investment outcome than simply recouping a missed opportunity for gains.

Which is the point of today’s post.

Rise Of The Machines

While I have written often on the dangers of both ETF’s and “Passive Investing” (See here and here), my friend Evelyn Cheng highlighted confirmed the same yesterday.

Quantitative investing based on computer formulas and trading by machines directly are leaving the traditional stock picker in the dust and now dominating the equity markets, according to a new report from JPMorgan.

 

‘While fundamental narratives explaining the price action abound, the majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals,‘ Marko Kolanovic, global head of quantitative and derivatives research at JPMorgan, said in a Tuesday note to clients.

 

Kolanovic estimates ‘fundamental discretionary traders’ account for only about 10 percent of trading volume in stocks. Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago, he said.”

As discussed on previously, as long as the algorithms are all trading in a positive direction, there is little to worry about. As Evelyn noted there is a LOT of money piling into these trades globally.

“‘Derivatives, quant fund flows, central bank policy and political developments have contributed to low market volatility’, Kolanovic said. Moreover, he said, ‘big data strategies are increasingly challenging traditional fundamental investing and will be a catalyst for changes in the years to come.'”

There are two other problems underlying the chase for ETF’s. While investors have been chasing returns in the “can’t lose” market, they have also been piling on leverage in order to increase their return. Negative free cash balances are now at their highest levels in market history.

The second problem, which will be greatly impacted by the leverage issue, is liquidity of ETF’s themselves. As I noted previously:

“The head of the BOE Mark Carney himself has warned about the risk of ‘disorderly unwinding of portfolios’ due to the lack of market liquidity.

 

‘Market adjustments to date have occurred without significant stress. However, the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.’”

 

And then there was, of course, Howard Marks, who mused in his ‘Liquidity’ note:

 

‘ETF’s have become popular because they’re generally believed to be ‘better than mutual funds,’ in that they’re traded all day. Thus an ETF investor can get in or out anytime during trading hours. But do the investors in ETFs wonder about the source of their liquidity?’”

What Howard is referring to is the “Greater Fool Theory,” which surmises there is always a “greater fool” than you in the market to sell to. While the answer is “yes,” as there is always a buyer for every seller, the question is always “at what price?” 

At some point, that reversion process will take hold. It is then investor “psychology” will collide with “margin debt” and ETF liquidity. As I noted in my podcast with Peak Prosperity:

“It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.”

When the “robot trading algorithms”  begin to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures as the exit will become very narrow.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause catastrophic spreads between the current bid and ask pricing for ETF’s. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments.

If you don’t believe…just go look at what happened on September 15th, 2008.

It happened then.

It will happen again.

But I get it. The markets seem to be in an “unstoppable” bull market. This time certainly “seems different” with ongoing Central Bank interventions. Besides, with interest rates so low, “there is no alternative” for investors to put money.

Therefore, why not fire your advisor, buy a low cost index and just ride the market? Because, things like “Robo-advisors” and “ETF herding” are symptomatic of a lengthy bull market advance where the pain of previous losses has finally been erased.

Client’s don’t pay a fee to chase markets. They pay a fee to employ an investment discipline, trading rules, portfolio hedges and management practices that have been proven to reduce the probability a serious and irreparable impairment to their hard earned savings.

Unfortunately, the rules are REALLY hard to follow. If they were easy, then everyone would be wealthy from investing. They aren’t because investing without a discipline and a strategy tends to have horrid consequences.

What’s your plan for the second-half of the full market cycle.

 

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JRobby's picture

"Is your algo confused? Call us now for information about our special algo therapy!"

AllOfGood's picture

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grasha87's picture

Trump and Jim Rickards both blame free trade and comparative advantage on the problems in the U.S., but here's why they are wrong:

https://bunky1787.wordpress.com/2017/06/04/jim-rickards-free-trade-a-bar...

Fake Trump's picture

Robots? Trump is one of them.

Pure Evil's picture

What would you rather have running the country?

1.) A robot,

2.) Satanic child sacrificing pedophiles in the Democrat party.

JRobby's picture

Fake Trump, 18 week troll. Assume paid to be.

gold rubeberg's picture

And if paid, someone's wasting their money. The best they can do for an unpredictable, emotional character like Trump is "robot"? Yikes ... love him or hate him, the last thing he is is a passionless automaton.

Obadiah's picture

going down bitchez

leverage=you crazy

 

More Richard Pryor

"That Nigger's Crazy" 

https://youtu.be/wg9fKFmtU3E?t=31

runnymede's picture

For all our technological scientific advancements, it's all about manufacturing sentiment. 

Humans be irrational

Likely will be our epitaph

VD's picture

when AI becomes sentient (far eclipsing human IQ), then "markets" will no longer be required, nor politics, nor most current systems; in fact, humanity will become redundant as our evolved offspring wipe us out; from homo habilis to homo sapien to homo siliconsis.

cougar_w's picture

Nobody gets wiped out. They just ignore us as irrelevant same as we ignore insects. Why waste a pico-second of effort stomping on ants and roaches? They are below recognition of any kind, don't even exist in the human world. Same will apply to us; we won't even exist in the machine world. Humans will be allowed to do whatever they want; scurry around, war among ourselves, cannibalize, die off, mutate into something else. Won't matter one bit. Just won't matter at all. Also means, we will be free to live our lives how we like, just as now, except the machines will be too busy to answer our stupid questions or step and fetch for our retard whims. So long as we can survive with stone tools and low/zero EROEI, we're good for another 5 million years and our distant relations will neither know nor care regarding the machines or from whence they came.

runnymede's picture

It's good to see there are other thinking persons out there. superfluity is indeed a bitch. Nature takes curious but completely understandable turns.

decentralisedscrutinizer's picture

 

Why waste time on this alligator when the swamp’s most critical economic and political problems revolve around the hegemony of a global corporate cartel, which is headquartered in the US because this is where their dominant military force resides. The US Constitution is therefore the “kingpin” of an all-inclusive global financial empire. These fictitious entities now own the USA and command its military infrastructure by virtue of the Federal Reserve Corporation, regulatory capture, MSM propaganda, and congressional lobbying.

 

The Founders had to fight a bloody Revolutionary War to win our right to incorporate as a nation – the USA. But then, for whatever reason, our Founders granted the greediest businessmen among them unrestricted corporate charters with enough potential capital & power to compete with the individual states, smaller sovereign nations, and eventually to buy out the USA itself. The only way The People can regain our sovereignty as a constitutional republic now is to severely curtail the privileges of any corporation doing business here. To remain sovereign we have to stop granting corporate charters to just any “suit” that comes along without fulfilling a defined social value in return. The "Divine Right Of Kings” should not apply to fictitious entities just because they are “Too Big To Fail”. We can't afford to privatize our Treasury to transnational banks anymore. Government must be held responsible only to the electorate, not fictitious entities; and banks must be held responsible to the government if we are ever to restore sanity, much less prosperity, to the world.

 

It was a loophole in our Constitution that allowed corporate charters to be so easily obtained that a swamp of corruption inevitably flooded our entire economic system. It is a swamp that can't be drained at this point because the Constitution doesn’t provide a drain. This 28th amendment is intended to install that drain so Congress can pull the plug ASAP. As a matter of political practicality we must rely on the Article 5 option to do this, for which the electorate will need overwhelming consensus beforehand. Seriously; an Article 5 Constitutional Convention is rapidly becoming our only sensible option.

 

This is what I think it will take to save the world; and nobody gets hurt: 28th Amendment

 

28th Amendment:

 

Corporations are not persons in any sense of the word and shall be granted only those rights and privileges that Congress deems necessary for the well-being of the People. Congress shall provide legislation defining the terms and conditions of corporate charters according to their purpose; which shall include, but are not limited to:

 

1, prohibitions against any corporation; a, owning another corporation; b, becoming economically indispensable or monopolistic; or c, otherwise distorting the general economy;

 

2, prohibitions against any form of interference in the affairs of; a, government, b, education, c, news media; or d, healthcare, and

 

3, provisions for; a, the auditing of standardized, current, and transparent account books; b, the establishment of state and municipal banking; and c, civil and criminal penalties to be suffered by corporate executives for violation of the terms of a corporate charter.

    

Infinite_Trench's picture

Totally agree but wouldn't "they" just pull the plug and wake up the PPT?

Pure Evil's picture

There are supposed to be triggers to close the casino for when the market drops a specific percentage.

Can't remember the exact name of the process.

cougar_w's picture

"When the robots reverse"

Talking like they are humans with riskOn/riskOff herd mentality. Sorry pal, doesn't work that way.

The programmers could instruct these things to have different strategies that eliminate emotions and fear. 1) Follow any down-turn for the first 5%, and then halt operations and wait for the PPT to step in, and 2) hit an API at The Fed to ask if they have adopted any of maybe a dozen market saving strategies, and if so, play the moves accordingly.

Meaning, absolute 100% market controls at the micro-second time slice.

Humans cannot do that. Machines 100% can do that and are already doing that. They can play this market (and the few remaining meat bags) into a 300% ROI over a couple years, the whole thing be 99% programmed, and you pukes would never know the difference. It just would never go down or at least not stay down. The banks (in on the deal) would rape the day traders and make off with the loot, free and clear.

AlexCharting's picture

I am very bullish on "ROBO Global Robotics and Automation Index ETF"

Deplorable's picture

Danger Will Robinson...Danger!

DaBard51's picture

Didn't "Adam Smith" write about this in "The Money Game" back in... 1967?

Pages 171-181 in my hardback...

 

When nine hundred years old you become, look this good you will not.

ThorAss's picture

Anyone who holds a leveraged ETF overnight is very brave.

withglee's picture

 “The plunge was extremely sharp but fortunately regained composure and shares rebounded. A ‘flash crash.’

One day, we will not be so lucky. But the point I want to highlight here is this is an example of the ‘price vacuum’ that can occur when computers lose control. I can not stress this enough.

Put in a 1 to 2 second random delay from a uniform distribution and "poof" ... the algos have to change their AI from a gaming mentality to an investing mentality. You don't have flash crashes with an investing mentality. 1 mili-second in and out does not an investment make.

Charvo's picture

"Buy and hold" always feels great at the top of the bubble.  Those same folks advocating for "buy and hold" will still say the same when stocks are down 50% off the highs.  The question is whether the investor can stomach that 50% decline without selling out in disgust and probably taking a major loss.  The fear of lower prices will outweigh the thought that prices will eventually rise up again.