March 10, 2017 Financial Planning 0 comment

Mechanical Investing

There are many different approaches to investing. Specifically, investing in stocks and bonds has evolved from individual securities to multi-layered products. At it’s core you are either an owner or a lender to a business. A major trend in the market the last 20 years which has accelerated in the last 5-7 years is the use of ETF (exchange traded fund) model portfolios. In 2016, $287.5 billion went into ETF’s. This brought the total ETF asset value to $2.56 trillion. (2016 ETF flows) These portfolios utilize low cost ETFs as their core investment. The ETF’s may own stocks or bonds. The general idea is that you gain exposure in a diversified manner to the public stock and bond market. In my opinion this approach has several positive and negative aspects.

The most obvious positive with this type of investing is the low cost of the ETF structure. In many cases ETF’s can cost less than 5bps. You also gain access to large number of stocks depending upon the ETF. This helps to reduce the risk that you would select an individual stock that performs much worse than the balance of the market. The largest ETF’s are based upon the market capitalization of the companies in a major index. The S&P 500 is the most common. Model portfolios typically give exposure to many other parts of the stock and bond market. Ranges are typically established and re-balancing may occur on a set schedule. This produces a very definable set of criteria from which the portfolio is managed. The largest single choice is typically the allocation to stock versus bonds. Some models will practice timing moves from sector to sector or investing domestically versus internationally.

There are also several problems that may arise with this approach. There is no research done to determine if the investment should produce a satisfactory return. The return expectation is simply whatever the aggregate stock index produces. In periods of rising markets this may produce returns that are acceptable. In declining or flat markets, the returns may not be acceptable. It assumes some level of investment is always warranted in a segment of the market. As history has demonstrated, segments of the market will have more or less interest at different times. This interest creates a valuation that will affect future returns.

The model based approach is very easy to implement and monitor. This has caused widespread adoption and now greater than 1/3 of all equities are owned via an index ETF or fund. The number may be greater if you include informal indexing done by institutions. This is creating a very homogeneous ownership base. The risk with such a base is that one or two changes will affect a large block of holders simultaneously. Those changes could be higher rates, a European bank failing, a China currency devaluation or some other event. My background in Biology reminds me that similar populations are very prone to large reductions in size the more similar the members. Diversity creates strength. In my view the current level of use of the ETF models has transformed a simple and useful strategy in to a potentially risky method of positioning.