There are actually two trends: 1) Move to ETFs: Clients have been moving away from high-fee hedge funds into passive funds (ETFs) where trading is generally simpler. 2) Automation: There used to be a lot of analysts working on reports to monitor fund performance, tracking error, trading costs, risk exposures and so on. They are being replaced by software.

Exactly, how can algorithm investing be truly passive investing?

There's a lot of confusion in the article.

Disclosure: I work for a company which does this stuff. I'm not in the financial programming side.

There are several things you can do.

For example, say you wanted to hold the S&P500, but as individual stocks rather than paying someone at a mutual fund or ETF to hold it for you. This might be beneficial in a number of ways, but it has the serious drawback of having to manage 500 entries. You might already own a dozen or two of those entries already, or you have overlapping purchases in other investments.

You could tell a smart portfolio management program to use the S&P500 list as a target, and tell it about all the rest of your current holdings. Then it could analyze your current portfolio each day and make recommendations about how to get closer to your target, while avoiding wash sales and duplicate purchases. If you trusted that program, you could feed the output to your brokerage and have the trades executed automatically. Or you could look at the output and make decisions about whether you want to make the changes. Either way, you are no longer doing analysis yourself, and you're edging closer to your target, at which point you would be passive.

On the other hand, suppose you wanted an approximation of the S&P500 -- a target that would give you most of the same exposure and opportunity, but had a reduced number of individual stocks. You could run simulations on subsets of the S&P500 until you got a group that performed sufficiently similarly to the whole thing - 300? 250? 100? 50? as you reduce the set size you reduce the fidelity of the model - and then buy and hold those.

You can do a lot with an algorithm, and if your strategy doesn't need to operate in realtime, it will certainly look passive compared to HFT bots. A human might not want to rebalance more than annually or quarterly, because it can be a lot of work -- but a robot has no problems doing all the calculations daily and looking for a sufficient reward to present to you.

Thanks for the explanation, there are 2 things I don't quite understand though.

What is the advantage of building a replica of the S&P500 with individual stocks rather than having it done with an index fund? Isn't the second option much cheaper?

Secondly, isn't finding a subset of the S&P500 and trying to replicate it still an active strategy?

Most investors are just like you and me. We have a basic portfolio which we needed managed cheaply.

But... huge amounts of assets are held by people/companies that may have odd holdings (ultra concentrated positions) or odd needs (liability matching). Those people/companies may need algorithms to help them move their portfolio to an optimal portfolio with minimum cost.

You can actually arb the SP500 components against the ETFs like SPY in a process that creates and redeems the ETF. This is how the ETF is kept in line.

I expect that there are tax advantages to holding individual stocks rather than an index fund.

Is finding a subset an active strategy? Depends. Do you do it every day, or do you figure out your subset and then buy and hold for fifteen years?

Is it passive when you rebalance against your target quarterly?

I think we can all agree that it's not passive when you are doing HFT, and anything which involves picking new stocks daily or weekly is active -- but having an algorithm do the rebalancing against your existing target daily and executing when a threshold is met? You're not making new picks, just readjusting against what you've already picked.

One tax advantage to approximating an index with individual stock positions is "tax loss harvesting": sell one stock at a loss and buy an equivalent. e.g., sell Coke and buy Pepsi. An advisor told me that you can add ~1% to your after tax returns. You need sufficiently large positions such that rebalancing transaction fees are negligible.

> I expect that there are tax advantages to holding individual stocks rather than an index fund.

None that I am aware of. Mutual funds can force capital gains realization, but ETFs do not.[0]

IMO there's no reason to roll your own index fund when you can just buy an ETF with a very low expense rate. If you have enough money that rolling your own (costs a fair amount to manage) is cheaper than the public fee, you might be eligible for a special shareclass rate anyway.

[0]: http://www.investopedia.com/articles/investing/090215/compar...

Here's one: as a US citizen living in Canada, I'm unable to invest in ETFs in Canada (e.g. Vanguard Canada's S&P500) without suffering punitive taxes and onerous reporting to the IRS. If it's an active investment, then it's fine, it's taxed as normal.

Unless you're playing with a million dollar, the fees for rebalancing are more expensive than any returns you might make. Especially if you have to trade hundreds of funds separately.

Don't rebalance quarterly either. Index funds are long term, meaning years.

Rebalancing ETFs is free or included in the price of a roboadvisor.