The toolkit of the modern investor

Summary: Passive funds have reigned supreme for a long time, but with market volatility finally rising, some claim we've reached an inflection point. 

Key take-out: It's 'machine factories versus craftsmen' as Macquarie puts it, but whether investors switch to active managers isn't the point. 

Considering current market volatility, investors should be getting active, even on their passive investments.

And, we could be entering a new era where more active fund managers will outperform their benchmarks – at least the ones who think outside the box. 

This would mark a departure from the status quo. Over the last 50 years, The Financial Times reports trading volume on the New York Stock Exchange (NYSE) increased 500 times, from 3 million shares per day to 1.5 billion. But if you were to assume that meant more traders sitting at their desks day in and day out, you would be very wrong. 

It's not news that much of this volume is passive money, driven by fund managers, funnelled into exchange-traded products.

Algorithms and artificial intelligence, albeit nascent, are fuelling our stock markets. FT estimates that institutional money now makes up more than 95 per cent of trading volumes. In a note put out last week, aptly titled Craftsmen in a world of factories, Macquarie estimated passive and quantitative strategies specifically account for 60-65 per cent of trading volumes on the NYSE, double what it was a decade ago.

Passive will exceed active

Passive assets under management are on track to exceed active assets under management by 2023. By rule, passive investing means you do no better, but no worse, than the average. People are happy tracking the index because over time the index has outperformed.  

“While there are still some isolated pockets where traditional trading rules, these are small anomalies and in any case they are also swept into the maelstrom of global trading patterns,” reads the Macquarie note, confirming the trend is playing out well and beyond Wall Street.

“Indeed, it is not all bad, in so far as it improves efficiency and eliminates human phobias. However, it also eliminates human ‘hesitancy’ and ‘thought’, with crowded repricing done in split seconds (in either direction) and hence 5 per cent-plus moves are now the new 1 per cent.”

That last part, about 1 per cent becoming the new 5 per cent, may send shivers down the spines of active managers looking for opportunistic entry points in all corners of the market. But there's a growing chorus that believes we are now at an inflection point. Market volatility could certainly provide more opportunity for price discovery.

'Machine factories versus craftsmen'

It begs the question: Can the little guy, or the smaller money manager, ever actually win?

Macquarie claims passive versus active is “a false dividing line” where instead it should be “machine factories versus craftsmen”. That’s to say, in Macquarie’s words, “think outside the box or join machines and lose” – any money manager can beat the market if they get crafty and creative.  

Of course, institutional investors still have a clear information advantage. There’s a direct, and very real, relationship between computer modelling and trading outcomes. It’s now possible for companies to crunch and recalibrate massive data sets to develop predictive strategies.

David Aferiat, co-founder and managing partner at US trading software company Trade Ideas LLC, says this should “eventually shift the pendulum” from passive strategies back to a mix where technology “generates actionable insight previously lost in the noise”. Perhaps that shift is already taking place.

“For the smaller money manager, this will be very good news indeed, as they and their end clients gain access to capture alpha rather than index performance,” Aferiat told Eureka Report from his office in Atlanta, Georgia.

“The new investors in the market over the last 10 years have yet to experience a bear market. When it comes – and some say we are just beginning it – passive portfolios will fall with the indices to which they are tied. Active investment managers, using the new tools for analysis in the market, stand to reap the most gains as investors seek out performance over and above index returns.”

An 'albatross' for large funds

Aferiat says active managers have “a fiduciary obligation to move up and out from the index” and he thinks smaller managers have a real edge here.

Aferiat is banking on AI and machine learning as key solutions. His business is powered by these very things and it caters to professional and active traders, including hedge funds, in the US, Canada, China and Europe.

“Firms can now crunch massive structured and unstructured data sets (social media, news, events, crowd sourced), run these against ‘what if’ scenarios and develop predictive analytic strategies, that more often than not substantially exceed index returns,” explains Aferiat.

“Opportunities for capturing alpha will only come more consistently to those with the ability to see patterns in the market where others cannot. The next phase in the market cycle must pass through a sufficient amount of uncertainty and volatility as suppliers and buyers find new equilibrium. This means volatility and adds another reason to apply the most advanced tools and analytics – such as AI, quant modeling and alternative data sets – to decision making.

“Delivered in a SaaS [software-as-a-service] based model, information advantages to achieve consistent effectiveness in trading can come from anywhere and not just the most highly capitalized, resource-rich hedge funds. Size and scale which were signs of strength at these funds, in fact, may be their albatross if technology adaptability and agility are lacking in the culture.”

Aferiat reminds that many of the technologies that sophisticated investors have come to rely on weren’t even envisioned a decade ago. Macquarie’s Craftsmen in a World of Factories echoes this sentiment. 

“Hence, the market’s pre-occupation with ‘Big Data’, just as a decade ago it was all about speed, and ‘web scraping’ has become the topic du jour over the last several years,” reads the note.

“From corporate websites and survey firms to drones flying over tankers or car parks, there is a frenzy of getting ahead of the curve. As in ‘Flash Boys’, eventually there will be nothing to scrape, as today there is no longer any meaningful speed advantage left, even in the ‘cloud’.”

They are 'complementary tools'

The re-emergence of volatility may bring a new dawn for active managers, which, by the stats, had their heyday in the US in the 1960s. But it’s unlikely to give rise to an active management renaissance, or so Dugald Higgins, head of property and listed strategies at Zenith Partners, seems to think. He tells Eureka Report that's because investors are increasingly fee-conscious, citing a recent article he wrote on the matter. InvestSMART is also bringing awareness to fees through its Compare Your Fund campaign.

Right now though, Higgins thinks investors, with so much money tied up in passive funds, need to give consideration to something else as well. He says there has "never been a more important time for investors to make active choices in their passive investments". He stressed the fact that many of the newer ETPs  boast indices that deliver materially different outcomes than their older and broader peers. Some ETPs that appear to be created equal are really not. 

So, what's the bottom line?

“People have really strong opinions about it, but active or passive, at the end of the day, they are just tools – sometimes investors prefer one tool over the other, but most of the time these tools are complementary and not substitutes for each other,” says Higgins.

Macquarie ends its note with an anecdote about Joan Robinson, a British economist, who attributed her success to an inability to master mathematics.

"We believe that this should be the mantra for active fund managers, particularly in equities," the note reads.

"Humans can’t compete on speed or pattern recognition but we can think. It is not an easy road as mandates usually encourage trading and discourage investment. Yet this is the only viable option: to be a craftsman, surrounded by factories."