We'll Always Have Paris

The past weeks are a stark reminder of the risks that we live with in the world today.

Such times trigger multiple questions, and their answers may be more vital than how we

invest. Nonetheless, how we plan and invest for our futures is of core importance.

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We’ve seen a significant move away from how most people invested in the 20th century—actively and with the at times costly advice and direction of advisors and brokers—towards a more digitally enhanced, passively implemented set of strategies. Some of that trend is inevitable and a useful addition to the suite of options. But as we have said, and continue to maintain, the rush toward passive investing is not without issues, and it must be balanced. There can be too much of a good thing. Today’s rush towards passive, ultra-low cost investing solutions must be tempered with questions: What is being gained? What potentially could be lost?

The question of the day in light of the events of the day

No period of human history has been free from substantial threats to order, and the attacks in Paris were a sharp reminder of threats that are particular to our time. Though these events occurred far from American shores, they felt quite close and quite possibly could happen here. Hence the outpouring of concern and the intensifying debate over how best to confront these threats.

In investing-land, we spend most of our time focusing on the gyrations of stock prices, the basis point moves in bond prices, whether the Fed governors will or will not do whatever it is they will or will not do, and whether growth will continue or stall. Those questions, seemingly consequential on most days, are quite secondary when juxtaposed to the events in Paris, as they should be.

Yet, there are lessons here to be learned for how we manage our money. One of the more heated debates in investing-land today revolves around the rise of passive investment vehicles. That includes the stunning growth of ETFs in the past decade, now more than $2 trillion spread among 1500 funds1. It also includes the rise of “robo-advisors,” which have garnered extraordinary attention, substantial venture capital, but only a tiny level of assets—around $20 billion.

And the passive debate also embraces all flavors of index funds, which offer exposure to sectors, regions, and asset classes without the cost, intensive research, and company-specific risks of owning individual stocks and bonds.

It is a debate that we heard continually at Schwab’s recent Impact 2015 summit, where thousands of managers, advisors, and others gathered for a few days of intense discussion and some other less intense diversions. But the recurring theme wasthe rush towards passive investments and roboadvisors, and it was a veritable drum beat.

It was accompanied by significant unease about the Department of Labor’s proposed rules to expand the fiduciary standard for retirement accounts. Considerable opposition to these proposed rules exists in Congress, and it remains to be seen whether the rules as written will be implemented. But within the financial advisory community and the asset management industry, the very possibility of a rigorous fiduciary standard has led some to move permanently toward purely passive and low-cost investing options. Their rationale is that such investing decisions made for their clients will not be challenged, whether or notthey generate optimal returns that meet long-term needs.

That is where Paris comes in. Axiomatically, no single passive investment vehicle currently exists that can both dynamically and instantly respond to a crisis, shift gears, and change how it invests. Only human agency can integrate rapidly new and unexpected information and then apply it to existing models and assumptions. It may be that few people may assess the implications of events correctly, but in this respect, human minds are much more nimble and capable than infinitely faster machines, and more effective than normally more-efficient algorithms. Machines and programs are far cheaper, far faster, and much more efficient when the basic assumptions remain unchanged. But as new variables enter the picture, those same machines and programs can, and often do, falter.

Any severely disruptive event can toss into disarray the quantitative assumptions underlying most passive vehicles. Quants may respond that they have factored in black swans and that the models are built on years of testing during which there were legions of external shocks that changed market behavior. Fair enough, but each new shock is in its way unique, and unless one believes that everything always reverts to a predictable and set mean, then past events can be only a partial guide to future outcomes.

Consider the shocks of 2011, most of which were political in nature, from the U.S. government shutdown and debt downgrade to the near implosion of the Eurozone over Greek debt. Markets were wracked with volatility from June through November. Most stock and bonds suffered losses and steep swings, and passive vehicles, of course, were along for the ride. As were many active funds, too many of which are, in fact, “closet” index funds. But only active managers during this period could make adjustments based on rapidly changing and unpredictable events.

Finally, there also is the tendency of money to flee when chaos erupts. When that happens, passive vehicles are the most vulnerable. Think of the $900 billion currently in bond ETFs. The ETFs trade as highly liquid daily shares, as they are designed to do. Many of the bonds that underlie them, however, trade hardly at all. Bond markets other than U.S. Treasuries tend to be dominated by far fewer buyers and sellers, and have more opacity. If investors en masse panicked as a result of a Paris-type event, a natural disaster, or any number of potential shocks, the mismatch between many ETFs and the actual liquidity of the bonds or derivatives that undergird them could be a severe risk for asset prices.

There is robust debate over this topic. Defenders aver that these concerns are misplaced, but the same was true about securitization and derivatives that precipitated the 2008 financial crisis. The point is not that passive investments and roboadvisors are inherently risky, only that a purely passive approach raises concerns that many investors and advisors overlook in the face of industry trends.

The proverbial upshot

Until we have genuinely thinking machines that can take new variables and unexpected events, analyze them in real time, and shift parameters accordingly, passive vehicles will succeed best as tools to execute strategies. They are less effective as strategies unto themselves.

Even if the Department of Labor fiduciary standard is implemented as planned, it will be yet another step towards placing the clients’ best interests at the forefront, rather than a call for advisors to remove themselves from active decision making. It may include not only using primarily low-cost passive investment vehicles, but also offsetting the risks and limitations of those strategies with active managers and direct ownership of assets.

In general, most binary solutions are limited, even though they are appealing because they scream simplicity. But as recent events remind us once again, the world we inhabit is not simple. It is changeable, variable, and prone to bursts of crisis. And in that real world, we need to attend actively to investing decisions—and indeed all of our decisions—if we wish to adjust and adapt to changed circumstances.

Karabell is head of global strategy at Envestnet, a leading provider of wealth management technology and services to investment advisors.

1 Source: ETF.com, http://www.etf.com/sections/daily-etf-flows/etf-fund-flows-2015-07-02.

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© Envestnet

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