Welcome to my latest video presentation. The article below is a condensed transcript; my video contains additional details and several charts.

 

It’s Friday, so I’m taking a break today from covering the daily gyrations of the markets to focus on two related themes: “passive investing” and robo-advisors.

The topic of robo-trading has become all the more urgent with the rise of artificial intelligence and the dangers that it poses. Algorithms (aka “algos”) dominate so much of Wall Street today.

The following dialogue comes from the 2003 movie Terminator 3: Rise of the Machines.

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.”

That verbal exchange could have come from the trading desk of any large asset manager. Machine trading has conquered Wall Street.

Be on your guard. The trend toward putting investments on auto pilot could pave the way for a crash.

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 indices have become a major factor for the recent volatility in stocks. These funds act as accelerants, up or down. They could make the next downturn worse.

During the 2008 global financial meltdown, regulators weren’t prepared for how derivatives and other quant strategies worsened the crisis. The 2010 flash crash occurred as a result of algorithms and automated programs that manipulated the market. The pandemic-induced market plunge of February-March 2020 also was exacerbated by program trading.

Wall Street seems to have learned nothing. Despite these risks, 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. By the end of 2020, 31% of global ETFs were managed passively. That figure is expected to reach 37% of assets by 2025, according to the latest data from PricewaterhouseCoopers.

It’s easier to make money with passive funds during a bull market. The true test comes 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. Don’t get me wrong: pooled investment vehicles, such as 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. The wisest stance is a combination of passive with active.

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.

Losing the Human Touch

In a closely related trend, we’re seeing the rise of automated investment services called robo-advisors. Introduced a few years ago, these services are being aggressively sold and are quickly grabbing market share. According to research firm Statista, assets under management in the robo-advisors market are projected to reach $2.76 trillion in 2023 and $4.66 trillion in 2027.

Robo-advisors are computer-based systems that set up asset allocations based on answers to a dozen or so questions about your age, risk tolerance, years to retirement and other basics.

Over time, the investment mix grows more conservative (e.g., there’s a greater emphasis on safe income stocks) as retirement draws closer. In this way they’re like target-date funds.

However, robo-advisors lack a personal touch. Their automated systems don’t account for a client’s personality or changing circumstances. Customized advice can add value, especially for complex situations or during bear markets, when a good financial advisor can be a voice of reason.

I’m confident that we’re currently seeing the birth pangs of a new bull market, but the economy remains battered by rising interest rates and still-elevated inflation. Amid today’s uncertainty, an active approach is more important than ever. It’s easy for the herd mentality to misread events.

If you’re not making your own decisions, you’re burying your head in the sand. There are proactive measures that not only protect your portfolio but also retain a growth trajectory.

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.

AI Investing With Robert Rapier

In the meantime, are you looking for new sources of profit amid today’s uncertain investment conditions? Consider the advice of my colleague Robert Rapier.

Robert Rapier is the chief investment strategist of Utility Forecaster, Income Forecaster, and Rapier’s Income Accelerator.

Robert is one of the world’s foremost experts on energy and income investing, but his deep knowledge also extends into other segments, notably AI.

Want to learn more about Robert’s money-making trades in the burgeoning field of AI? Click here.

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John Persinos is the editorial director of Investing Daily.

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This article previously appeared on Investing Daily.