New systems and big data shaking up investment management world
It is predicted that over the next five to 10 years investment management will become increasingly systematic and not rely on gut feelings and whims
Investment management is in flux, arguably more than it has been in a long time. Active management is under pressure, with investors switching from active to index funds.
New “smart beta” products offer low-cost exposures to factor investing, a domain that has historically belonged to active management. Exchange traded funds are proliferating. Markets and regulations have changed significantly over the past 10 to 20 years. Data and technology, which are increasingly important for investment management, are evolving even more rapidly.
Seven key trends are helping to predict the future of investment management, at least over the next five to 10 years. These are active to passive; increased competition; changing market environments; big data; smart beta; investing beyond returns; and fee compression.
The first three present challenges for active management. But the fourth trend — the explosion of available data and related technology (machine learning and artificial intelligence) to analyse it — is definitely positive.
Today, standard financial data is available to everyone with an internet connection — billions of people — though, of course, successfully investing by using those data still requires training and skill.
Beyond financial data we have seen an explosion in availability of large unstructured data sources that are so vast and so available that access alone is no longer sufficient. The edge now lies in identifying which data is useful and in analysing and effectively processing them.
Big data represents a huge positive trend for active management, particularly for active managers who embrace the opportunities presented by this development. A closely related advancement, machine learning-artificial intelligence, provides the tools to fully access and analyse this large amount of unstructured data.
To gain the benefits of this trend, active managers will need to hire people with skills in these areas — computer scientists, statisticians, data scientists, and applied mathematicians. These people are different from those active managers have typically hired, and they bring different skills.
The next trend in investing is smart beta or factor investing. Smart beta products are active products with some of the benefits of index products. They are “active” in that the goal is to outperform traditional market benchmarks like the S&P 500 or MSCI World. They are transparent and rule based, like indexing, with fees closer to traditional index products.
Smart beta products provide exposure to broad and persistent factors that have long been a part of active management. For equities, these include small size, value, momentum, quality and low volatility. For fixed income, the factors include duration and credit. These factors have generated investor interest because they have performed well historically. Beyond that there are reasons to believe they will continue to outperform in the future, on average over time.
Factor investing is not new, but smart beta products have been growing rapidly over the past few years, and they are not without controversy. They are disrupting active management and threaten indexing, with their promise of additional return above the market, while retaining the low cost and transparency of indexing.
Smart beta-factor investing is more than just a new product though; it is a disruptive innovation for active management. It’s odd to call it an innovation at all. These ideas have been around for decades, have long been a part of active management and historically they contributed to successful active management. But this isn’t an investment innovation, it’s a product innovation. Smart beta-factor investing takes important components of successful active management, carves them out, and sells them for fees below active fees. That’s the disruptive innovation.
Nothing is wrong with an active manager delivering smart beta. Investors just need to understand what they are buying and pay a fair price for it. Investors shouldn’t pay active fees for factor exposures if they can achieve the same outcome in a low cost smart beta solution.
Pure alpha is the part of active returns not resulting from smart beta factors. Delivering pure alpha returns must be a key focus of active managers going forward. Only active managers can deliver pure alpha. Investors need all the returns they can get, whether from smart beta or pure alpha.
The clearest and most promising sources of pure alpha are ideas that involve informational inefficiencies — processing publicly available information faster than the market. If smart beta factors are broad and persistent, pure alpha returns come from more narrow and transient ideas. This is the area where big data and machine learning can significantly contribute.
Success in pure alpha will require strong research capabilities because many pure alpha ideas will last only until the market understands them. Continuous generation of new ideas is critical for long-term success. Success in pure alpha will also require financial engineering skills to hedge out smart beta exposures.
Though the future of investment management is a big topic, a central arc traces through its history, and its trajectory predicts what will come in the next five to 10 years. Investment management is becoming increasingly systematic. Systems, analysis, structure, and understanding — built on increasingly available data — are replacing gut feelings and whims.
• Kahn is an MD and global head of systematic equity research at BlackRock.
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