Okay! advisors are not perfect but is it enough reason for the media wave against them? One may argue that somebody has to take the responsibility for underperformance, and thus it’s time for retribution. But before we choose the robots over the advisors, and see passive investing as a solution for all investors, we need to ask some hard questions.
Robots cannot be the only truth. So the question we need to ask is how long will this last? And, if there is a future beyond robo-advisors? The assumption that hedge funds are weaklings and passive investing is superior to active in all aspects does not hold water. If a hedge fund index does not deliver, how can the complete industry be rotten? Will active investing die a natural death and all hedge fund managers make wine while passive indexing shines?
No, that will not happen. The regulation can always stifle and bring in more entry barriers and accountability to the industry, but nobody wants to suffocate an age-old practice that continues to sail smoothly. Active investing will have to up its game though -- and the game is not over yet. That’s because to assume that motif investing offered by some robo-advisors is the best available itself is an illusion. Similarly, the assumption that investors can make the best investing decisions by themselves just because they were smart enough to choose the low-fee option is flawed thinking. Investor education and awareness is necessary but surely not sufficient to make one a great manager or a risk manager. If such a transition was possible, there would not have been advisors and managers in the first place.
To assume that passive investing is great and even Donald Trump would have done better for himself investing in S&P 500, is the passive industry shining under its own spin.
Active will fight back
So why have advisors and managers done a miserable job? Is it because they don’t know their job? Or is it because the market complexity has increased, while the skill set of market players is still pegged to the wisdom of Graham and Dodd, which is more of a franchise than a handbook for current times. Whatever be the reason, to assume that a multi-trillion-dollar active investing industry, multiple times larger than the passive industry will not fight back after hitting magazine covers that mock its trickling performance is wishful thinking. When everybody knows it’s bad, the worst could be behind you.
Sentiment is not an objective science. Let’s understand a bit more regarding what’s missing. It’s like my first day at B-School. This was in 1996 -- we were asked to play a stock market game. Bets were made with every new information that came in. While the floor at the school was insanely exchanging notional profits and losses, we had little appreciation of the 1965 Fama’s disertation arguing for random walk hypotheis, suggesting that information arbitrage is a wasteful exercise, and it’s better to buy the market any day rather than trade on the information. This is the 30-year cycle. A relevant and robust thinking takes about 30 years to get accepted by the society.
There is never one Truth
There is never one truth. Nature works with multitude and sequence of truths. Truths are like those thousands of turtles stranded on the beach, just a few reach the ocean, as many are chunked away by the birds of prey. The truths go through their own journey, to be seen or not to be seen, only a few surviving the 30-year cycle and getting mainstream. There are many truths with cycles of their own; 60 years, 90 years etc. Schrodindger’s and Schumpeter’s multiplicity of cycles is another story.
Coming back, while Fama and French were sowing seeds of efficient indexing in 1960’s for the motif robo-advisors of today (who are still a bit more advanced than the robo-advisors who are clueless about history), 60 years earlier in 1900 it was Bachelier who was writing the basis for modern finance. It also took nearly 30 years before Kolmogorov credited Bachelier with the early insights on the Markov Process.
According to the S curve (Verhulst, 1845), the old truth should get marginalized by the new truth, but the process is not sudden. There is a mathematical progression flowing like an S, it starts slowly, grows rapidly and hits a ceiling. This is why even if stock selection theories get challenged as inferior sciences, these theories will never die. It’s like Paul the Octopus, non-science, but tradition. A generation will die believing in its truths, even if the nonsense was obvious.
Smart and dumb
And then if science couldn’t explain it all, Barabasi could, calling it the luck factor. So businesses and startups working on an old truth should still get some investors to fund because just like businesses there are investors low on their appreciation of the S curve. For the smart money to win, dumb money has to lose, the statistics have to stack up for unexplained science (truth not discovered) to be assumed as luck. The Google opportunity is not for everyone. For that, a lot of ducks have to stack up and one definitely needs to know a bit of history.
The motif robo-advisors who are embracing the three decades old 3F idea don’t own the truth. Because while F&F were laying the foundation for indexing, there were researchers like Boulding (1950s) who were explaining the architecture of information and how information moves through stages of relevance and irrelevance and that inefficiency exists with efficiency.
It’s true that active managers have not delivered versus passive benchmarks, but that does not mean inefficiency is unprofitable and active investing will vanish. Markets don’t work on passive utopia only, it needs multiple agents for markets to keep moving from inefficiency to efficiency incessantly. And if you think it’s only active managers that thrive on inefficiency, you should be surprised to know that passive investing as an industry not only generates inefficiency but thrives on it. This is where Bogle comes in. “Why do you waste time on style…they are inefficient…just buy the benchmark.” Bogle sees no reason for motif’s and differentiation. His argument; all that’s inefficient will be efficient someday. But then just because Bogle believes in something does not eliminate investor’s expectation of excess returns coupled with low-fee and and maybe even negative excess volatility. That’s why Smart Beta companies have thrived. This is what I mean by multiple agents and the need for different arguments, for the industry to work.
What’s the solution?
Investors cannot become managers. Motifs are eye candies, which increase ratings for some time but ratings should not be confused with performance. So if you will tell investors that they can be managers, drivers of their own fate, you are showing them a mirage, which will eventually shatter owing to mismatched expectations, “you did not tell me so.” Money management is a skill, which has to translate from a human to a system. When systems become supreme, that’s the end of markets. Systems improve as our understanding of complexity improves. Better the science, better the risk management. It’s a journey. ETF’s are vehicles. Vehicles don’t conserve or make money, risk management does. Robo-advisors are vehicles, don’t confuse them with financial nirvana, even if it feels good burying your stone age fund manager for a new virtual motif.
