Trouble Ahead! Hedge Funds Lose, Robo-Advisers Win… For Now

There’s a big problem brewing on Wall Street. It’s going to cause the next catastrophic stock market meltdown.

And just as surely, it will present us with an absolutely massive profit-taking opportunity.

What’s the problem?

It seems that all of a sudden, Wall Street’s computer-driven quantitative-trading strategies aren’t working very well.

According to Bloomberg, “Program-driven hedge funds are stumbling, a promising startup has closed and once-reliable styles are showing weakening returns…

“This isn’t just normal volatility confined to a single month… Returns have been decaying for a year.”

Uh-oh…

The root cause of the problem is that there isn’t as much so-called “dumb money” in the stock market anymore.

These days, many retail, mom-and-pop investors are investing with so-called “robo-advisers,” a totally different sort of computer that helps folks allocate their money more intelligently and without the help of a human financial adviser.

As far as computer-based trading goes, these robo-adviser systems are very simple.

They ask you questions about your age and retirement goals and then allocate your money according to the conventional wisdom based on your answers.

If you’re older, the robo-adviser will allocate your account more toward bonds and less toward stocks. If you’re younger, you’ll get more stock exposure. You get the idea. It’s really basic stuff.

But since a computer is making the choices, it’s cheaper than paying a human expert.

Nearly every broker is offering some kind of robo-adviser service these days.

Schwab, Fidelity, TD Ameritrade, Vanguard — all the big brokers are in this market now. Plus, a bunch of new startups.

All the Computers Do The Same Thing… That’s Bad News

But there’s a major problem with robo-advisers: They all pretty much do the same thing.

And when everybody is investing in the exact same things (even if those investment allocations are generally good ones), there can be some very bad unintended consequences.

The first one is that news above, that a bunch of hedge funds using quantitative strategies are seeing their returns plummet.

That’s not such a bad thing — I’ll tell you why in a moment.

But the much scarier question is what happens if we experience a sharp correction in the next year or two while a growing mountain of money is all invested in the same thing?

As the first round of investors suck money out of robo-adviser funds to have extra cash on hand, the robots have to start selling the stuff they own to cover the redemptions.

And as that selling pressures prices to drop, it creates an echo chamber for the folks still holding on — the start of a very bad chain reaction that could send prices plummeting.

Worst case, I think this robo-adviser trend could spark the next stock market meltdown.

Best case, it’s still going to continue breaking a lot of the strategies that Wall Street has been using.

That’s great for us. Here’s why…

Even if Robo-Advisers Lead to a Crash, You’ll Be Ok

There’s a colossal difference between how I view the markets and what the quant funds on Wall Street do.

By now you know all about the Archimedes trading platform I spent years building by hand, one line of code at a time.

It has a lot more in common with the computer intelligence being developed in Silicon Valley right now than it does with the quantitative platforms being used by Goldman Sachs or the various hedge funds feeling the burn of awful performance this year.

That’s not just lip service.

Archimedes looks at stocks from a totally non-Wall Street viewpoint. Stock price data aren’t all that different from other datasets, really. What I’m really doing with the Kinetic Strategy Archimedes uses is separating the signal from the noise.

The Kinetic moves that happen year after year are the signals that I’m focused on — those signals are impossible to spot with the naked eye because they’re obscured by noise in the stock market. But Archimedes has no trouble filtering that noise out.

And my long-term back-testing data show that it works.

On the other hand, Wall Street spends most of its research resources trying to predict distinct events — earnings, product sales, news, etc.…

They’re literally spending all their time trying to predict the unpredictable random noise in the market! It’s total insanity.

I’m not surprised their quant funds are breaking. This backward line of thinking extends throughout the industry.

Applying Silicon Valley tech to the stock market gives you the freedom to explore relationships and phenomena that Wall Street simply can’t. And not being tied to a hedge fund also gives you the ability to dig deeper into smaller stocks that the institutions can’t touch.

If robo-advisers really do push the market out of whack, the smaller stocks that aren’t included in major indexes that the robos invest in are likely to be drastically underpriced, too.

That’s exactly how the next big Wall Street crisis could pay for your new beach house.

 

Sincerely,

Jonas Elmerraji

Jonas Elmerraji

The Daily Reckoning