Are the robots coming to take our jobs and ruin our pensions?
I have a dystopic vision of robots and computers making investment decisions and trading stocks, bonds, and currencies, while hordes of ragged former portfolio managers, analysts, and brokers roam the decrepit streets of the City and Wall Street shouting about earnings misses and bid-offer spreads. A little dramatic maybe, but the industry is facing massive challenges from lower returns and digitalisation. Active managers are under pressure from passive strategies while financial repression has reduced the opportunity set for alpha generation. Things have to change. My less traumatic vision of the future is a new kind of alpha – one that doesn’t promise too much, that incorporates responsible investing, that charges lower fees than in the past but retains the flesh and blood anchor to what is essentially a branch of the social sciences. It’s true, asset management needs to embrace technology faster than it has, it needs to industrialise and become more efficient than is currently the case. But the industry needs to be careful not to throw the baby out with the bath water. Active can thrive if passive is dominant and people will always need to make judgements about other people’s decision making. The utopian version of the future is one where smart people work with smart machines to deliver smart investment outcomes. But if rates and volatility stay low, what needs to change is expectations. Greed has no place in the brave new world.
The asset management industry is faced with profound challenges. Low financial market returns in the post-financial crisis era have contributed to the general decline in fees for asset managers. Low returns and reduced volatility have made it more difficult to generate traditional alpha through stock picking, asset allocation, and macro calls. This has fuelled the rise in lower cost passive investing. At the same time digitalisation and the application of artificial intelligence and data science is threatening the traditional fund manager role. There is an underlying theme that advanced quantitative techniques can do a better and cheaper job of exploiting anomalies in market pricing than a human can. Recently I read some arguments suggesting the industry is heading towards a domination of passive investing at almost zero fees. How can the industry survive in its current form if that is to be the case?
Active won’t disappear completely
Of course, I am an advocate for active investing. I feel strongly that a purely passive approach can lead to a misallocation of capital. It’s a well understood argument in the bond market where market weighted bond indices draw investors into taking passive risks that might not be appropriate. Capital is allocated to the largest debtors. In recent years, a passive approach in a government bond index would have led to longer and longer duration exposure. In a credit index, the average quality has declined given the rise in BBB-rated bonds in the overall asset mix. At the same time, returns have fallen as yields have trended lower. In equity markets, I struggle to see how a stock’s valuation can reflect its fundamentals if capital is allocated to it just based on it being in an index. Maybe I don’t get it, but if all equity investing was passive then there would be no judgemental influence on a stock’s price despite changes in its earnings profile or its valuation. I guess not all passive strategies are the same and allocations to growth or value indices could impact on relative performance of stocks, but it does my head in to think that there could be a time when all investment capital in equity markets was allocated by algorithms that just allocate money on a pro-rate basis.
But lower expectations and do it more cheaply
Yet at the same time active management has been disappointing. My own view on this is that expectations are too high to begin with. With very rare exceptions, the track records of active investors rarely live up to the hype. The performance of absolute return funds in recent years is an example. Investors have been sold a story that market neutral, absolute returns funds could deliver positive stable returns in any market conditions with a very low correlation to equity markets or interest rates. Some have, at times. But more and more this has become a difficult investment outcome to deliver. The tendency for interest rates to go to zero and the commensurate narrowing of risk spreads in bond markets gives little opportunity to exploit market inefficiencies in fixed income. And to be honest, the one big macro theme of the last three to four years – the clear outperformance of the US economy relative to Europe – has been one that has not been exploited by macro investors overall. It was a slam dunk macro trend that a lot of people got wrong.
Think about the new active
The world of active is changing. My colleagues in our judgemental equity team have been focussing on bigger picture structural themes and how they will impact on relative equity performance in coming years. These themes include things like the “digital economy”, “ageing and lifestyle”, and themes around some of the environmental and social factors I discussed last week. Active equity investing is no longer about picking the right stocks ahead of earnings announcements – although that clearly remains an important aspect of an equity fund manager’s role – but about trying to harvest longer term risk premiums that are driven by profound changes to the global economy. In the bond world, regular readers will recognise my enthusiasm for trying to exploit different risk premiums in fixed income – carry, duration, inflation, and credit risk. I was looking at the performance of the European credit market in April and there was a clear outperformance of higher yielding bonds. By actively tilting the credit exposure a portfolio manager could have easily beaten a passive strategy. Picking the right bond on the rates curve or the right credit in a particular sector may still produce a little bit of alpha but getting the bigger picture allocation right over longer periods of time is where the real alpha generation will come from. Following on from last week’s theme, ESG will also be part of the new alpha as non-financial factors will allow fund managers to differentiate themselves from each other and from passive index followers. This does not need to be expensive either. Industrialisation of back-office processing, more efficient use of trading platforms, and the more judicious use of research can help reduce the structural cost base in asset management. Of course, regulatory headwinds have not helped in recent years, but this only goes to accelerate the changes that would have happened anyway.
Science and economics
The industry is changing and responding to the challenges. You have more chance of getting a job in asset management these days if you have a data science degree rather than an economics degree. Responsible investment analysts are more in demand than people that can understand a balance sheet and profit and loss account. But isn’t there a risk that there will be loss of the investment theses in all of this? Capital is allocated based on the best anticipated risk-adjusted returns, this necessarily means human knowledge and instinct should instinctively continue to play a role. How would a data scientist interpret Jay Powell’s press conference after the FOMC meeting this week? How would a passive portfolio respond to the improvements in recent Chinese macro data? As long as decisions at the policy level (central banks), at the corporate level (managers), and at the consumer levels are taken by real people, there is always going to be room for other real people to make judgements about what those decisions means for rates, credit, and equity valuations. Computer science may get more and more sophisticated but human behaviour, reflected through political, business, or consumption decisions, is more complex and not always predictable.
Combining new and old
At any rate, the bight new world of asset management is not in everyone’s grasp. It is expensive for a start given the investment necessary in the right staff, computing power, and data managements. Most asset managers, certainly those of scale, have legacy businesses, clients, and strategies that can’t be jettisoned because they deliver the bulk of assets under management and revenues. New strategies will be important at the margin. I am particularly interested in how fundamental and quantitative techniques can be used together – a theme known as “quantamentals”. Indeed, the two approaches have always been used together but the more sophisticated data science becomes, the more mainstream the combination of fundamental views with powerful screening or other quantitative methods can become. This will be important in further incorporating ESG into mainstream investment management. Active judgemental investment techniques can set the overall risk profile of portfolios or asset allocation strategies while quantitative techniques can be best employed finding the right securities and allocating risk accordingly.
For now, the Fed is in control
But enough of the big-picture pondering already. This week we had the Federal Reserve (Fed) reiterating that it will be keeping interest rates on hold for some time. Yet Mr. Powell did not provide anything new for the economic bears. The US economy is doing fine and the recent decline in inflation is seen as temporary. I will have finished writing this piece by the time the April employment report is released but, based on other recent labour market data, it is likely to confirm that employment growth remains strong in the US. Central banks elsewhere, notably in the UK, Canada, and Sweden, have also reiterated monetary policy on hold. For bond investors that means duration remains an attractive risk premium even if flat yield curves mean that this is not that much scope for longer yields to go lower. In the US it will be an interesting few months if the data continues to show a 2.5% growth rate, inflation coming back a little on the back of higher oil prices, stronger wage growth, and the passing of some transitionary factors that have depressed inflation in recent months. The battle of wills between President Trump and the Fed is also likely to become more entertaining the closer we get to the election. So far, independent monetary policy is retaining the moral high ground with two of Trump’s candidates for a Fed position having withdrawn from being considered. They were not seen as suitable candidates for the Federal Reserve. That remains a mighty institution and it is in the interests of all investors that it retains its independence from political meddling. The Fed is not infallible but faced with what it sees happening in the US economy today, I think it is doing the right thing by keeping its options open. Don’t fight the Fed. On the contrary, stay long risk assets while the Fed is at bay. However, a note of caution for bond investors. The returns in Q1 were spectacular. Return momentum has faded significantly in April though. It’s hard to see what the next kicker for bond returns is if the Fed is on hold. Spreads are back to last summer’s levels in the credit markets, rates can’t go much lower unless economic growth really falters. High yield and emerging markets should provide goods returns but core fixed income is looking a little more boring than was the case in the first few months of the year.
Messi the leveller
So Manchester United might not finish in the top four and might finish below Liverpool for only the 3rd time since the Premier League was launched in 1992-93 but they got the same result that Liverpool achieved at the Nou Camp. No matter what the hype is, as long as Barca have Messi the sublime is always possible, as was shown last Wednesday. It will be a big ask for Liverpool to reach the final of the Champions’ League now and a Barcelona-Ajax final is looking the more likely outcome. I suspect the residents of Madrid would prefer that outcome too. That would be a classic European final contested by the two teams that, over the decades, have played the beautiful game most beautifully. And there have been close links between the two, Cruyff, Van Gaal, Kluivert, Koeman and Zlatan amongst others. Nothing is guaranteed in football, so a boring 1-0 to Messi might be the outcome if it is indeed an Ajax-Barca final, and of course one or both English teams might get through. But romantics can hope that a thrilling 5-4 special is on the cards on 1st June.
Have a great weekend,
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