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Valuations, Algorithms, and ETFs: A Toxic Mix

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“Abnormally good or abnormally bad conditions do not last forever.”– Benjamin Graham

The recently ended month of May was the worse month for the markets since the December 2018 swoon. Overall, in the U.S., the equity markets declined almost -7.00% while markets around the world also suffered in varying degrees. After four impressive months to begin the year, the markets in May became increasingly cautious over growing, wide-spread signs of economic weakness, rising valuation levels, and the continuation of trade tensions with several important trading partners, most recently with Mexico added to the list.

Within this market environment, professional investors have sought new methodologies to generate a return on their investment capital. One of the more recent tools has been the use of algorithms to profit from inefficiencies in the broad market. In essence, algorithms are complex mathematical models that operate totally without human intervention. As an example, should the algorithm find a discrepancy between the value of an index and the value of the underlying securities comprising the index, the algorithm automatically sells the higher valued component while simultaneously buying the other component. While the profit from this transaction is usually not huge, the algorithm can perform this task in fractions of a second and can repeat the process an unlimited number of times. In this way, a large amount of capital dedicated to such a program can produce very attractive returns for the investor. Unfortunately, one of the unintended consequences of this practice is that it tends to exacerbate market movements, either to the upside or the downside. In the month of May we had another demonstration of how this process can create turmoil in the markets, making the individual investor question why they are even involved in such as unpredictable marketplace.

While ETFs have been available in some from or other for a couple of decades, ETFs have experienced an explosive growth in assets under management following the financial contagion of 2008-09. The individual investor began to realize that they were incapable of outperforming the popular market indexes nor could they identify professional investment managers who could consistently beat their benchmarks. As a result, investors found a viable alternative in ETFs that were constructed to mirror the performance of almost every market index as well as baskets of commodities and other asset classes. Today, there is several trillion dollars invested in ETFs with many investors feeling they have addressed the performance issues uncovered in 2008-09 and are well prepared to face the economic and market uncertainties that lie ahead. However, once again, the individual investor may have unwittingly exposed their investment assets to another form of risk.

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MVP June 2019 Valuations, Algorithms, and ETFs FINAL
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