Is Passive – Index Fund Investing Over? Are Robo-Advisors Doomed?

By in Advanced Investing, Money Management, Mutual Funds | 2 comments

Is There a Dark Cloud Hanging Above a Passive Index Fund Investing Approach?

Most, although not all, of the robo-advisors practice some form of a passive index fund investing approach. This type of investing is based upon widely accepted and well researched investment practice that demonstrates that it’s extremely difficult for actively managed funds to beat the performance of the major market indexes such as the S&P 500 and others.

Are robo-advisors are doomed?

Robo-advisors are doomed - or maybe not

What if Everyone Started Investing in Index Funds? Does That Mean Robo-Advisors Are Doomed?

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 rob-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, in 2013, it made the headlines 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 on to a sinking ship?

I 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.

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  1. Hi Barb – I get what you’re saying about index funds, but my bigger concern about robo advisors is how they’ll survive a bear market. They mostly came out on the heals of the last bear market, and its been straight up from there.

    I’m trying to figure out if they’re truly something revolutionary, or if they’re just the latest technological innovation in a very long bull market. It will be interesting to see how they fare. If they survive a bear market, they’re here to stay, maybe even if index funds fall out of favor.

    Kevin Mercadante

    February 21, 2016

  2. Hi Kevin, Good point. Investors have a history of letting fear drive their investing decisions and tend to bail during down markets. This current 2016 market may provide some evidence for your theory. Personally, I don’t believe a bear market will drive investors from the robo-markets, nor do I really believe that indexing will hurt robo-advisors. My prediction is that as the field gets more and more crowded, the main players will evolve and that the big investment companies such as Vanguard, Schwab, Fidelity etc. have a real advantage due to their large existing customer base. That said, I believe the robo’s fill a need in the marketplace for (generally) low fee investment management.

    Barbara Friedberg

    February 21, 2016

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