Active Trading vs Passive Investing Tipping Point

Posted on August 6, 2012 at 12:30 PM PDT by

The active trading vs passive investing argument can finally be put to rest. Will the last human being trading stocks please get the lights?

We have long known about high-speed trading by computer programs, so-called “high-frequency trading.” But as Jason Zweig recently pointed out in The Wall Street Journal, things have taken a turn for the ridiculous.

Active trading vs passive investing, robot edition

Last week, on the day the Federal Reserve was to announce its course on rate policy, stocks went nuts at the open. Volumes spiked by a factor of 20 on a broad selection of widely held shares. Some fell 10% and then corrected.

Zweig commented:

So much for the reassurances from regulators and stock-exchange officials that a repeat of the “flash crash” is impossible. Wednesday’s tumble wasn’t quite as scary as the nearly $1 trillion drop of May 6, 2010, but it conveyed the same sense of markets spinning out of control and trading machinery going mad.

Whenever journalists get worked up about active trading vs passive investing and the goings-on around Wall Street — even a journalist as clued-in as Zweig — it can be easy to dismiss. More trading means more liquidity, right?

But this is fundamentally different from a few brokerages flipping switches. We’ve gone from humans seeing eye-to-eye on a floor to machines engaged in something akin to a lightning-speed cage match to the death. Algorithms now spin through thousands of scenarios and toss millions of trades at each other in a bid to outmaneuver all comers.

It’s fascinating, but horribly dangerous for individual investors. Forget amateur day traders. Even the smartest, most capable professional manager is fast becoming an absent-minded crossing guard on a NASCAR straightaway. Active trading vs passive investing as a discussion has become moot. It’s really survival vs a painful, retirement-destroying disaster.

Active trading vs passive investing, roadkill edition

Zweig’s observations come at a ticklish moment: For the first time ever, Bloomberg News reports, the value of the biggest exchange-traded funds (ETFs) tracking the S&P 500 Index is very close to exceeding the combined trading value of the stocks themselves. We’re at a tipping point.

Here’s the breakdown from Bloomberg:

Dollar volume in the SPDR S&P 500 ETF Trust, the iShares S&P 500 Fund and the Vanguard S&P 500 ETF reached a 12-month average of $28 billion a day last month, 98 percent of the trading in the index’s companies, which include Apple Inc. (AAPL) and Exxon Mobil Corp., data compiled by Bloomberg and Goldman Sachs Group Inc. (GS) show. Investors have flocked to the securities that mimic benchmark returns after the financial crisis increased swings and correlations between assets.

The takeaway for the rest of us humans should be easy to grasp. Whatever claim to relevancy active money managers had is quickly disappearing. Not only is trying to beat the market virtually impossible, even sticking your neck out in the active trading vs passive investing fight is an invitation to get walloped.

That’s why we recommend a neatly assembled, well-allocated portfolio of low-cost ETFs, passively managed funds with usually over $1 billion in assets and which cover broad indexes and exercise disciplined rebalancing, thus allowing the portfolio to work its compounding magic over the years.