When people think of Wall Street, they often picture the classic clamor of a stock exchange floor. But much Wall Street activity now takes place more quietly, as computers increasingly handle passive investment strategies.
Passive investment strategies are the result of algorithms run by complex computer programs without direct human involvement. The strategies are rapid, automatic, and high-volume, capable of thousands of trades per second. They have become increasingly dominant over the past decade. Marko Kolanovic, global head of macro quantitative and derivates strategy at JPMorgan Chase, estimated in a report last year that passive and algorithm-based "quantitative investing" accounted for about 60% of all stock trades. More traditional methods accounted for only 10%. Stock exchanges earn money by selling access to instantly-updated data feeds of market activity; Nasdaq, for example, earned roughly a quarter of its revenue from such information services.
The strategies generally respond to the same market signs as humans. Some use their speed to recognize and take advantage of tiny price fluctuations, buying and reselling rapidly. Others try to be predictive based on analysis of wide swaths of data, including everything from labor-market news releases to the word choice and tone of political speeches.
One popular strategy is passive investment in ETFs, or exchange-traded funds. Such funds use computers to track financial indexes and general market trends instead of relying upon humans to select individual stocks. ETFs are listed on public exchanges, making them easy to trade. Cheap ETFs and index funds have blown up since 2009, and now have 40% of market share in the U.S.
Index funds and ETFs have propelled BlackRock and Vanguard, the two largest providers, to power. Both BlackRock and Vanguard use sophisticated computer programs to channel investments into global indexes. The funds tend to favor major index players like Facebook (NASDAQ: FB), Apple (NASDAQ: AAPL), and Amazon (NASDAQ: AMZN), raising their valuations even higher. Large hedge funds also increasingly rely upon computer-driven indexes that measure market swings.
We can thank these strategies in part for carrying the market to such dizzying highs. But these strategies can also worsen or accelerate steep declines, as we saw earlier this month. Passive market strategies promote uniformity in response to market movement, which may extend falls. Technology is certainly not solely to blame for the stock market turbulence. But programmed trading can compound existing volatility.
On Monday, February 5, for instance, the Dow Jones industrial average tanked 700 points in a span of 20 minutes. By Tuesday, February 6, it was up 567 points. While it is difficult to measure the exact role the passive trading played without auditing data, many pointed to algorithmic trading as a cause for the flashing, spiky nature of the highs and lows. Treasury Secretary Steve Mnuchin said that passive strategies "definitely had an impact" on Dow's 1,175-point dip. And in 2015, a group of global financial power players cautioned that algorithmic trading has been responsible for "significant volatility and market disruption" and carries "the potential for systemic risk...over very short periods."
Still, some are more sanguine, confident that over the long term these cheap funds tracking a broader index will still perform better than expensive, particularized stock programs put together by humans, and that increased volatility is ultimately not a major concern.
Regardless, passive trading strategies won't disappear or even slow down anytime soon, absent intervention from either the U.S. government or the exchanges themselves - neither of which seems likely.