The CFA Institute recently solicited video submissions about the future of global investing, an irresistible lure to those inclined to share predictions from their “crystal ball.”
December is a big month for predictions, and it isn’t uncommon to see forecasts of gloom and doom receive a lot of attention. My vision of the future incorporates skepticism about popular narratives, particularly the alarmist narratives that forecast impending doom. I expect a recession and bear market to occur at some point in the next five years, but I think it unlikely that we’ll experience a financial “meltdown” over that period.
My submission to the CFA Institute highlighted 5 disruptive forces influencing the future of global investing. I think these forces are vitally important, but will not “crash” the market in the next five years:
1. Artificial intelligence, big data and machine learning will be disruptive forces, but humans will still play an important role in providing investment management and financial advice.
Quantitative algorithms are increasingly used to identify past patterns and subtle trends in large sets of data. Quantitative models may be superior to humans in looking through the rearview mirror, but humans still may be better equipped to identify future trends. AI, big data and machine learning may be less effective when outcomes are uncertain and subject to a high degree of randomness. There are numerous variables that influence the direction of markets, and it is easy to underestimate the human element of judgment.
Investor sentiment, government policy, geopolitics, and “luck” (including weather and other random influences) all may play a significant part in explaining investment performance. In many cases, decisions must be made in a context of unexpected developments, infrequent in nature and with limited historical data. Consequently, AI may not ever be a replacement for the judgment of a Warren Buffett, George Soros or Janet Yellen.
Human advisors spend much of their time helping clients balance between goals that have financial as well as emotional elements. The emotional element is much harder to codify and capture for AI than the financial element, and typically requires trust, nonverbal insight and intuition. Empathy and trust are frequently cited as the most important attributes distinguishing human advisors from automated investment solutions, and those attributes aren’t likely to decline in importance. It’s often said that technology offers both threat and opportunity, but the cliché fits the current state of the investment management industry. Advances in technology represent a threat, but successful firms will embrace the opportunity by combining the judgment and creativity of humans with the systematic analytical capability of computers.
In the words of renowned hedge fund investor Paul Tudor Jones, “No man is better than a machine, no machine is better than a man with a machine.”
2. Index funds will continue to gain market share, but actively managed funds will still play an important role in the market.
A Sanford Bernstein report, The Silent Road to Serfdom, portrayed passive management as a form of socialism. The Bernstein report characterized index investors as “free riders” benefiting from market prices set by an endangered species of active managers. Under a doomsday scenario, active funds would become “extinct” and be replaced entirely by passive funds.
Without the price-setting involvement of active managers, extreme deviations between market prices and the intrinsic value of securities would be inevitable. The rise of index funds is a significant investment trend, and annual outflows of hundreds of billions of dollars from actively managed funds show no sign of abating. However, the higher the proportion of passive investment in an asset class, the more likely that market prices will diverge from “fair” value. Increases in mispricing relative to fair value will inevitably draw money back into actively managed strategies.
Although many mediocre managers will be driven out of more efficient asset classes such as U.S. large cap, it may still be difficult for active managers to beat their index. The elimination of some of the weaker investment managers may leave only the strongest active managers in competition with one another. The extreme competition among the best and the brightest of highly skilled managers could lead to a perverse environment in which the role of luck plays an even larger role in determining success.