A little over a month ago I wrote, “One Reason I’m Worried About The Rise Of The Robo-Advisor,” arguing, “as this form of investing becomes more and more popular, the risk of mispricings (and even bubbles) in the markets grows with it because it completely abandons the basic process of analyzing value and risk.” Buying ETFs through a robo-advisor is merely making a decision to own stocks (along with a few other asset classes) without any regard for price (or value). And while this is probably the right thing to do for most investors it can lead to a situation in which investors pour money into stocks at very unattractive values and push prices even higher because there is no natural price sensitivity to curtail them (see my bacon analogy in the earlier post).
What I didn’t recognize at the time is that this is a problem that is much bigger than the small but growing world of robo-advisors. Peter Atwater writes:[blockquote2]Today’s equity markets are dominated by the post-2000 growth in both futures contracts, particularly the e-minis, and ETFs. E-mini average daily volume in 2000 was just 67,820 contracts versus 1,510,352 last year. On the SPDR S&P 500 ETF Trust average daily volume in 2000 was under 8 million shares. Last year, the average daily volume was 122 million shares. The average NYSE trading volume, by comparison, for 2000 was 1.04 billion shares versus 2.6 billion shares in 2007 and 1.4 billion shares in 2013. The 2013 figure also includes the NYSE ARCA and NYSE MKT volumes. While none of these statistics are likely to have been much of a surprise, I think they convey how profoundly different the drivers of equity prices are today from a decade and a half ago.[/blockquote2]
The growth that we have seen in the past 14 years in these types of index products, before robo-advisors have even made a peep, is absolutely astounding. They have gone from becoming a trading tool for a handful of professionals to the outright drivers of day-to-day stock market performance. How did this happen? Josh Brown explains:[blockquote2]In 2005, fee-based accounts directly managed by financial advisors and brokers totaled $198 billion. As of year-end 2013, that figure had soared to over $1.29 trillion – more than a sextupling in under a decade. It is safe to say that, while some of these fee-based accounts are managed actively (brokers picking stocks, selling options and whatnot), the vast majority are not… Vanguard, State Street and iShares are to this era of investing as Janus, Fidelity and online day-trading were to the 1990′s. In fact, Vanguard’s share of all fund assets – now approaching 20% or $2.3 trillion – is the vexillum behind which the entire do-less movement marches. What this means for the very character of the stock market and the way it behaves is very important. It means that, almost no matter what happens, each week advisors of every stripe have money to put to work and they’re increasingly agnostic about the news of the day.[/blockquote2]
They are also agnostic about investment value. Whether stocks are under- or over-valued makes no difference to them. They put the numbers into their asset allocation software and put the money to work regardless. Fundamental investment analysis never enters the equation. And when you meet diminishing supply (due to stock buybacks and acquisitions) with insatiable and price-blind demand you get the stock market we’ve witnessed over the past few years – a rip-snorting bull that pushes prices to extreme levels.
When I wrote the earlier article I was more worried about these affects of robo-advisors in the future. Now, in light of these new facts, it looks like my worries have already become reality.