The rise of the financial machines

The job of capital markets is to process information so that savings flow to the best projects and firms. That makes high finance sound simple; in reality it is dynamic and intoxicating. It reflects a changing world. Today’s markets, for instance, are grappling with a trade war and low interest rates. But it also reflects changes within finance, which constantly reinvents itself in a perpetual struggle to gain a competitive edge. As our Briefing reports, the latest revolution is in full swing. Machines are taking control of investing—not just the humdrum buying and selling of securities, but also the commanding heights of monitoring the economy and allocating capital.

Funds run by computers that follow rules set by humans account for 35% of America’s stockmarket, 60% of institutional equity assets and 60% of trading activity. New artificial-intelligence programs are also writing their own investing rules, in ways their human masters only partly understand. Industries from pizza-delivery to Hollywood are being changed by technology, but finance is unique because it can exert voting power over firms, redistribute wealth and cause mayhem in the economy.

In the past decade computers have graduated to running portfolios. Exchange-traded funds (ETFs) and mutual funds automatically track indices of shares and bonds. Last month these vehicles had $4.3trn invested in American equities, exceeding the sums actively run by humans for the first time. A strategy known as smart-beta isolates a statistical characteristic—volatility, say—and loads up on securities that exhibit it. An elite of quantitative hedge funds, most of them on America’s east coast, uses complex black-box mathematics to invest some $1trn. As machines prove themselves in equities and derivatives, they are growing in debt markets, too.

All the while, computers are gaining autonomy. Software programs using AI devise their own strategies without needing human guidance. Some hedge-funders are skeptical about AI but, as processing power grows, so do its abilities. And consider the flow of information, the lifeblood of markets. Human fund managers read reports and meet firms under strict insider-trading and disclosure laws. These are designed to control what is in the public domain and ensure everyone has equal access to it. Now an almost infinite supply of new data and processing power is creating novel ways to assess investments. For example, some funds try to use satellites to track retailers’ car parks, and scrape inflation data from e-commerce sites. Eventually they could have fresher information about firms than even their boards do.

Hey Siri, can you invest my life savings?

The greatest innovations in finance are unstoppable, but often lead to crises as they find their feet. In the 18th century the joint-stock company created bubbles, before going on to make large-scale business possible in the 19th century. Securitisation caused the subprime debacle, but is today an important tool for laying off risk. The broad principles of market regulation are eternal: equal treatment of all customers, equal access to information and the promotion of competition. However, the computing revolution looks as if it will make today’s rules look horribly out of date. Human investors are about to discover that they are no longer the smartest guys in the room.

Source: The Economist magazine article here.