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Algorithmic selling risk of your money

25 May 2020, 01:00 by Peter McGahan

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OVER my last 32 years, I have seen many a ‘latest fashion’ encourage investors to run toward emptying their bank accounts.

There have been financial advisers with scruples, with a full understanding of their own competency and limitations, and there have been others.

The last few months have naturally brought up the passive investing debate. Passives, are funds like an exchange traded fund, or tracker for example, where a computer, or algorithm, buys your stocks.

Sold as cheap access, against the ‘over charging, badly managed funds’ these funds attract(ed) significant capital inflows.

They have a place for sure, but you have to be buying them for the right reason.

Faced with ‘low to nothing’ interest rates, investors took to the stock market to produce returns on their hard-earned capital. Behind the scenes, for reasons still beyond me, Central Banks pushed up stock markets by purchasing more and more equities.

Such interference seems wildly non-capitalist. We wrote about this countless times over the last few years, and how passive investors could find themselves in a bubble.

Consider the UK FTSE100. It is effectively a themed index, which moves from heavier weightings in tech stocks (year 2000) to energy stocks etc.

Simply tracking that index would mean you hold what it holds. An investment into the FTSE100 in 2000 would leave you with a drop from over 6800 down to close to 6000 today. That is 20 years.

The oil spat between Saudi Arabia and Russia, as well as the complex other geopolitics behind that, coupled with a handy dose of Covid has been a fantastic potion of doom for energy companies which dominated your pension/ISA portfolios through passives.

The doom potion above creates opportunities and risk of course.

A passive/algorithm investor cannot read those risks or potential opportunities and will indiscriminately sell/fall with the markets.

Unlike an investment choice where a team of economists/researchers/analysts/managers look at the prevailing conditions and what they might mean to individual stocks or geo-economics and decide: ‘that’s over priced, don’t buy it, or take profits, exit’, the passive places no importance on that on the way in, or out. It’s simply a surge for the entrance or exit based on an algorithm.

Such funds are often considered as ‘renting’ in the market rather than owning. Their principles of buying a stock are not based on economic fundamentals, and so they easily sell, taking prices down with it.

The world’s three biggest fund managers shed over $2.5trillion of assets during the sell off to March 15th.

For the record, that is a lot.

The theory of a positive feedback loop easily became a negative feedback loop. Passive investors in Amazon for e.g., buy the stock, irrespective of market fundamentals. Its price rises, it attracts more buyers and becomes more inflated and attracts more buyers. The reverse also becomes true.

Central Banks have inflated markets and will probably want to stay that course as seen with the surge in investment through capital injection over the last few months. Perhaps the biggest risk to markets in the future will be the day they reverse such a measure.

Such intervention has created a positive feedback loop where 40 per cent of the Nasdaq is now a concentration in just five stocks. That is extraordinary.

Thinking of comparing performance? When a bland comparison of performance or risk of passives v actives is created, it is highly misleading. You are simply comparing data based on what something does during a market condition as opposed to how it is actually managed.

That is like comparing a politician with a real person.

Passives have to be understood fully outside of the numbers (i.e. with true qualitative data) and used appropriately to create a portfolio that is fully balanced and ready to best deal with every market condition as is possible.

No one knows when markets will fall or rise, or bounce back. We do know when a market or stock is overpriced/undervalued and we do know how to stabilise our boat in rough seas by purchasing assets that are not highly correlated to each other.