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.

Active fund managers have had a good 12 months, but a terrible ten years

coin flip

When it comes to choosing an index-tracking, or passive fund management, investment a lot of people choose a manager who tries to beat the market by picking the best stocks, because that sounds like a great idea.

The tricky bit is finding the right manager. The temptation is to look at past performance but fund managers rarely beat the market for long.

The average fund manager is always going to struggle to beat the market (this is a separate argument from whether markets are “efficient”). That is because the index reflects the performance of the average investor before costs. In a world dominated by professional fund managers, there aren’t enough amateurs for the professionals to beat. Even the hedge funds, those supposed “masters of the universe”, haven’t been able to do it; Warren Buffett looks set to win a $1m bet on the issue.

The table, from Standard & Poor’s, shows how many European-domiciled funds (investing in a wide range of markets) have managed to beat the market over one, three, five and 10 years. Eight out of 19 categories managed the feat over one year, but that drops to four categories over three years, three over five years and none over 10 years. In most categories over 10 years, you had a less than one-in-five chance of finding a fund that beat the market.

The Economist fund table

So why do so many people think they can pick a winner? The answer may be found in a new paper from James White, Jeff Rosenbluth and Victor Haghani of Elm Partners that shows people find it very difficult to tell skill from luck. Suppose you have two coins, one fair and the other biased 60% in favour of heads. How many parallel tosses would you need to be 95% certain (statistically speaking) of identifying the rigged coin? They asked 700 financial professionals the question and their median guess was 40. The actual answer is 143.  If you widen the experiment to three coins, the number rises to 220.

The authors then use a thought experiment, which assumes that 15% of fund managers can generate a post-fee return of 1% a year relative to the market while the other 85% lose 1%. They put 1% of the portfolio a year into each fund and then shift more to the winners each year, based on the probability that they can continue to outperform. Even after 10 years, the expected return on this portfolio is -0.6% a year, relative to the index.

Read the complete article on The Economist web site.

New study reveals most stocks aren’t good investments.

Most stocks aren’t good investments is the conclusion from a study of stock market returns by Hendrik Bessembinder, a finance professor at the W. P. Carey School of Business at Arizona State University.

Exxon is among the top wealth-creating companies that have been publicly trading — under the name of a predecessor, Standard Oil of New Jersey — since the inception of Professor Bessembinder’s tally in July 1926. Others include General Electric, IBM, Altria, Coca-Cola, DuPont, PepsiCo and Schlumberger.

He relied on a database developed at the University of Chicago, known as CRSP, for the Center for Research in Security Prices, that contains virtually all publicly traded stocks in the United States. The Center for Research uses rigorous and logical criteria to determine when stocks enter and depart its listings, with some results that may seem surprising at first glance.

General Motors, for example, ranks eighth. It was publicly traded in 1926, but the list says it ceased to exist in June 2009. A company called General Motors exists today, of course, but as Chloe Fu, senior support and relationship manager at the Center for Research in Security Prices, explained it, G.M.’s bailout and bankruptcy led the center to declare the old company terminated, with a new G.M. coming to life in June 2009. Consequently, the new G.M. returns aren’t included in the total for G.M. on the list.

The list is a fascinating ranking of big winners in the stock market. But for a variety of technical reasons, it isn’t a straightforward table of the greatest wealth generators in market history. For example, the long-term gains generated by Exxon Mobil and its predecessors are understated because of the database’s limited duration and strict criteria.

Exxon Mobil’s wealth in the list doesn’t include Mobil’s, which Professor Bessembinder’s listing says, ceased to exist in November 1999, when it merged with Exxon. And going back further, both Exxon and Mobil were among the descendants of the Standard Oil trust, established by John D. Rockefeller and his partners in the 19th century. The total wealth generated by the cluster of companies derived at least partially from the trust — which also include Amoco and Chevron — doesn’t appear in a single notation, because of the list’s logic.

Other apparent oddities are explained by Professor Bessembinder’s application of the center’s criteria. There are two companies on the list called AT&T, for example, neither capturing the total net wealth generated by an investment in the old American Telephone and Telegraph Company at its 19th century inception.

To start with, the “old” AT&T, a.k.a. “Ma Bell,” is ranked 17th. It is said to have gone out of existence in November 2005. Another AT&T appears in the 33rd spot. That company came to life in March 1984 as Southwestern Bell, spun off from the old AT&T as a result of an antitrust suit. A descendant of Southwestern Bell bought the AT&T name in 2005 and operates under it today.

Other AT&T cousins are on the list: Verizon, as well as Comcast, which resulted from a merger between AT&T Broadband and an older company also known as Comcast.

Read the complete article on the New York Times.