Thursday, 26 March 2015

Resurrection of the Machines?



From the 19th century Luddites’ destruction of labor-saving equipment to Deep Blue’s defeat of chess Grandmaster Garry Kasparov in 1997, humans have historically had an uneasy relationship with machines. So perhaps it should not have been a surprise that the plight of computer-driven hedge funds was welcomed with a sense of glee in recent years. Throughout 2013 and most of last year a plethora of press articles described how systematic trading strategies were “broken” and unable to interpret post-crisis financial markets.

Yet there are signs that the trading machines are ready to rise again. After three straight years of negative returns, performance rebounded in 2014 and has continued into this year, with the group gaining 17% over the past 12 months according to Hedge Fund Research’s HFRI Systematic Diversified Index. In contrast, the broader hedge fund universe returned 4%.

Proponents of these systematic or “trend-following” funds blamed easy monetary policies for the lackluster performance. They noted that the intervention of central banks created an artificial cushion that dampened market volatility and limited the sharp moves that these strategies typically capitalise on. Indeed, most gains in recent months came from the unexpected crash in oil and surprising decision by the Swiss National Bank to remove the franc’s peg to the euro.  

Also referred to as “quants” or “black boxes”, systematic funds occupy a niche space in the hedge fund world. The strategies, which manage a total of $317 billion according to BarclayHedge, generally trade futures contracts in financial and commodity asset classes and profit from sustained price trends. Whereas many traditional fund managers analyse economic data and scrutinize corporate balance sheets, systematic trend-following strategies largely focus on historic price behavior and are agnostic about the direction of markets.

It is sometimes forgotten that computerized systems often require vast teams of humans to improve their efficiency. One of the most successful systematic managers, Winton Capital, spends $30 million annually on research. Accordingly, there is little room for a macho trading-room culture, with the highest paid employees often programmers and quantitative researchers. Winton’s founder, David Harding, has no interest in giving opinions on markets and until his dog Cosmo’s passing, allowed the cocker-spaniel stay in the boardroom during meetings with investors.  

Aside from some eccentricity, many investors dislike the volatile returns from systematic funds; a consequence of the strategies staying in markets during tumultuous periods when most logically-minded humans get out. However, the absence of emotion paid off in 2008 as many high-profile systematic strategies made double-digit gains when stocks and commodities plummeted. Similar selloffs may not occur in 2015, but diverging monetary policies could lead to market disruptions and an extension of recent profitable opportunities, says Anthony Todd of Aspect Capital, which manages $5 billion.

Even so, investors will not easily forget painful memories of three consecutive losing years. Instead of a replacement for human managers, computer-driven strategies will likely be categorized as a good complement to investment portfolios. The machines are not ready to take over just yet.

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