Robo-advisors face a new threat: Passive investing

A passive investing strategy is a type of investing focused on well-researched investment practice. Many of the robo-advisors use this investing strategy that shows how difficult it is for actively managed funds to outsmart the performance of the major market indexes. What does this mean for the robo-advisors?

 What if everyone started investing in index funds?

How would this phenomenon impact the robo-advisors, many of whom practice an index fund investing approach? Would this mean that most robo-advisors are doomed?

The argument that if everyone practiced an index fund investing approach then markets would cease to be efficient and their alleged advantage over active management strategies would go away has been around a long time. I remember back in the early 2000’s when I was in my MBA program this very conversation came up in one of my investing classes.

If this premise is true, and the majority of robo-advisors’ platforms are based on a passive index fund investing approach, then what might happen to the industry? Now bear with me a moment, as it seems a bit silly that I’m questioning the longevity of what is basically, an industry in its infancy. Yet, it’s important to understand all facets of an investment approach, in order to be an informed consumer.

Are robo-advisors at risk of failure due to an impending crash of the passive index fund investing trend?

First let’s hear what Charlie Munger, Warren Buffett’s long-time business partner has to say:

“Index funds will be permanent owners who can never sell. That will give them power they are not likely to use well.” ~from “A Billionaire’s Warning on Index Funds” by Jordan Wathen of the Motley Fool at CNN Money.

Then there’s Mario Gabelli, legendary value investor (as a side note, I invested in a Gabelli fund for many years), who contends that index funds weaken corporate governance. He goes on to say that index funds typically don’t question corporate management’s activities which leads to governance that may not be in the best interests of the shareholders.

To substantiate this allegation, it made the headlines in 2013 when a Vanguard index fund manager voted against directors at Hewlett Packard.

From a purely statistical viewpoint, when everyone is buying the same stocks, it would be impossible for those stocks to outperform as there would be no counter party on the other side with which to trade and they would necessarily have to underperform.

So does this mean that index funds are doomed to underperform and that the robo-advisory industry has jumped onto a sinking ship?

We don’t think that robo-advisors are doomed.

In spite of their seeming expansive popularity, index funds represent less than 1 in every 5 investment dollars. There still exists thousands of actively managed mutual and exchange-traded funds. Additionally, there’s no shortfall of investors looking to try their hand at stock-picking. You don’t need to look any further than the combined DIY/robo-advisory platform Motif, to see the multitudes of folks that want to try their hand at stock selection.

IFA advisors, one of the earlier financial advisory firms that recommended a passive index fund approach responds to the concern about the future of a passive index fund investing approach;

“If the adoption of indexed strategies became so pervasive that market efficiency were impaired, it would be a self-correcting process. Mispriced securities would create opportunities for investors to earn profits in excess of their research costs, and their activity would drive prices back to equilibrium levels.” ~from IFA.com

IFA went on to report that even if every professional investment manager went “index” there would remain other market participants buying and selling individual securities and making a market. These other investors would include corporations who buy back their own stock, companies that acquire other firms and thereby purchase their stock, corporate officers who buy their companies stock, as well as individual investors. It’s highly unlikely that ‘everyone will become a passive index fund investor’.

Another chink in the ‘indexing will doom the market’ armor is this conundrum; If large company stock performance is mainly governed by passive investors buying index funds, without regard to the fundamental underpinnings of the company performance, then why did Marathon Oil lose -55.5% last year and Hormel Foods gain 51.8%?

The ‘Robo-advisors are doomed’ takeaway

The argument against indexing has been around for a long time. Just because there are differing investing viewpoints, further suggests that a passive index fund investing approach won’t become ineffective anytime soon. Thus, when considering whether the robo-advisory industry may be doomed to fail, you can likely rest assured that it’s not going to happen anytime soon.

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DISCLAIMER: This article expresses my own ideas and opinions. Any information I have shared are from sources that I believe to be reliable and accurate. I did not receive any financial compensation in writing this post, nor do I own any shares in any company I’ve mentioned. I encourage any reader to do their own diligent research first before making any investment decisions.