Automated trading strategies and the risk of FAANGs biting

Jamie Hambro, Chairman of James Hambro & Partners, outlines why he is worried about the growth of automated investment trading strategies.

Jamie Hambro, Chairman, James Hambro & Partners

The popular film The Big Short, which chronicles 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 Twain ever said this, but the wisdom behind the quote remains – false confidence is dangerous, and as we enter 2019 we should be questioning our own assumptions and popular preconceptions.

One issue of serious concern is the increasing reliance on algorithms to populate investment portfolios. It is estimated that by 2021 $1.6 trillion of European investor cash will be invested in computer-driven Exchange-Traded Funds (ETFs) that automatically buy the component companies of market indices such as the FTSE 100. In the US the figure is set to reach $5.9 trillion.[1]

“Passive” strategies, as they are known, may now represent as much as 40% of the US market.[2] In the past decade $1.3 trillion of money has been taken out of active US mutual funds, and $1.6 trillion has been invested in passive funds.[3]

Research indicates that in the UK passive strategies are now responsible for around 50% of inflows, which means the passive share of the market is growing rapidly here too.

Good reasons to hold passives

The reason these strategies have taken off is that 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.

Increasingly, though, I am concerned that reliance on automated investing is reaching a dangerous level.

Smart beta

A subset of ETFs focuses only on shares that meet criteria such as high yield or growth companies.

These are called “smart beta” funds, and they have been growing at $70 billion a year since 2007. Smart beta assets are now estimated to represent more than 4% of global assets under management.[4]

Herd mentality

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, like the FAANGs did until recently, 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. Markets always overshoot – and therein lies great opportunity for the smart investor. But the next bear market could see the tendency to overshoot become more extreme than ever, leaving investors in these smart beta strategies particularly hurt because their portfolios cannot adjust quickly enough.

Arguably, the domination of the FAANG stocks makes this scenario more likely. The five FAANG stocks combined have a market value of over $2.8 trillion – more than the GDP of the UK and more than 10% of the S&P 500.

As we have seen recently, these shares are not immune from problems – Facebook is 37% down from its 2018 year-high on the back of its tussles with regulators and the media. Apple has fallen 32%, with iPhone sales disappointing. Netflix is down 36%. Even Amazon is down 24%, while Google (listed as Alphabet) is down 16%.[5]

We have not had much serious volatility since 2008, and algorithmic trading has only really taken root since then – so it has not been tested. In October we saw the S&P 500 lose 7% in a month and the volatility continued through the rest of the year.)[6]

This may be just a small foretaste of what could happen in a bear market. It could also be a sign that normal market corrections are becoming more violent than we have become used to.

Positioning portfolios

So how should investors respond?

There may be a natural reluctance to sell a long-held share if it triggers a Capital Gains Tax event, but we are reaching the point in the cycle when it pays to focus carefully on whether valuations fairly reflect a company’s prospects.

It may be worth retaining cash to take advantage of a market correction – we are holding more cash in portfolios at the moment than we have ever done.

Nearly all passive instruments follow an index or a subset of an index. A handful of firms, like the London Stock Exchange and S&P Global, have established powerful brands and highly profitable businesses providing these indices. Investing in index providers would be a less obvious way to gain potential exposure to the growth of passive investing.

As ever, as active investors our investment approach entails seeking to maintain client wealth by investing only in companies we have researched and understand.

4 January 2019

This is not advice and you should not act on the content of this comment without taking professional advice. References to specific companies are not recommendations to buy or sell securities issued by those companies. Opinions and views expressed are personal and subject to change. No representation or warranty, express or implied, is made of given by or on behalf of the Firm or its partners or any other person as to the accuracy, completeness or fairness of the information or opinions contained in this document, and no responsibility or liability is accepted for any such information or opinions.

The value of an investment and the income from it can go down as well as up and investors may not get back the amount invested. This may be partly the result of exchange rate fluctuations in investments which have an exposure to foreign currencies. Fluctuations in interest rates may affect the value of your investment. The levels of taxations and tax reliefs depend on individual circumstances and may change. You should be aware that past performance is no guarantee of future performance.

[1] Source: PwC analysis

[2] https://www.oaktreecapital.com/docs/default-source/memos/investing-without-people.pdf

[3] Source: Investment Company Institute 2017

[4] Source: Bernstein 2010 to July 2017 quoted in Lazards: The six sins of smart beta

[5] Source: Bloomberg, to 2 January 2019

[6] Ibid