The popular film The Big Short, which chronicles the sub-prime origins of the 2008/9 crash, opens with a quote attributed to Mark Twain: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
There is no evidence to show that Mark Twain ever said this, but the wisdom behind the quote remains: false confidence is dangerous, and we should always question popular assumptions and preconceptions.
One issue of serious concern is the increasing reliance on algorithms to populate investment portfolios.
It is estimated that by 2021, $1.6tn (£1.2tn) of European investor cash will be invested in computer-driven exchange traded funds. In the US the figure is set to reach $5.9tn.
Passive strategies may now represent as much as 40 per cent of the US market. In the past decade, $1.3tn of money has been taken out of active US mutual funds, and $1.6tn has been invested in passive funds.
Research indicates that in the UK passive strategies are now responsible for around 50 per cent of inflows, which means the passive share ofthe market is growing rapidly here too.
Good reasons to hold passives
We all know why these strategies have taken off: they are not only cheaper, but have performed better than many actively managed funds, particularly in markets like the US.
We use them ourselves where and when appropriate. For example, while we invest directly in company shares, we sometimes use ETFs to add diversification – they can offer broader exposure across a market and can be traded cheaply and quickly.
Reliance on automated investing may, however, be reaching a dangerous level.
A subset of ETFs focuses only on shares that meet criteria such as high yield or growth companies. These ‘smart beta’ funds attracted $77.6bn last year – up 12.4 per cent on the $69.1bn recorded in 2017. Nearly 500 new smart beta ETFs were launched by 145 managers last year.
If an ETF is programmed to buy shares that, say, have positive momentum, then it could be forced to buy shares that a rational investment manager can see are heading into bubble territory.
If lots of money is following this momentum strategy it will amplify the trend, driving certain shares (like the so-called Faangs – Facebook, Amazon, Apple, Netflix and Google) ever upwards.
On the back of this, these big companies become even bigger, forcing simple passive fund strategies to buy more and more, building the momentum further into a positive feedback loop.
Many active managers can find themselves under pressure to be part of this, because deciding to ignore a share that is rising can seriously impair your relative performance.
In effect, the market is being mechanically herded and distorted. And then something happens – a profit warning or a regulator intervention – to reverse the trend. At this point computers become forced sellers. Falling markets trigger more sell signals. There is suddenly an about-turn and a dramatic fall in the share price.
What has been disproportionately bought will have to be disproportionately sold – assuming buyers can be found.