News & Insights

1/11/2016

Tired of the passive vs active management debate? Prepare for AI vs human managementby Eric

For the past decade, investors from around the world have flocked from active investment strategies to passive strategies. In the U.S., last year alone, US$250 billion moved out of actively managed mutual funds and into passively managed index funds and ETFs.

These figures are the latest proof of a fundamental shift in investors’ preference, which has been motivated by the continued underperformance of the majority of active managers.



But even though the latest round has been clearly in favour of passive strategies, the current split of flows between passive and active (see graph) is unlikely to be remembered in the future as asset managements’ version of Francis Fukuyama’s The End of History. In fact, history in this industry is set to be impacted by something much more threatening: Artificial Intelligence (AI).

Just Before we dive into Carl Sagan and everything AI, let’s take a serious look at the hard reality the asset management industry is currently facing with human portfolio managers.

A recent report by S&P Dow Jones Indices found that 59.7 per cent of large cap funds in Australia failed to beat the ASX200 index in the most recent financial year. This number increased to 69.2 per cent over a five-year period. Similar findings have been recorded in previous years and the same trend is being repeated in markets around the world.  

Back in the in the 1960s, the Economics Nobel Laurate Eugene Fama demonstrated that stock price movements are impossible to predict in the short-term and that new information affects prices almost immediately. The idea of index investing came from this school of thought. While there is a portion of the market that is actually outperforming the indexes they are measured against, these are exemptional cases. The odds of anticipating and consistently beating the market are very low.

There are still some good human portfolio managers out there who do outperform their benchmarks. These humans should be given a lot of credit for delivering the alpha that they justifiably charge for. But for the most part, active management is an extremely hard thing to do, and the skillset of successful managers is almost impossible to transfer from human to human.

The issue with human active management

Talking about transferring skills, let’s look at the case of the legendary institutional investor Peter Lynch, who managed Fidelity’s Magellan fund between 1977 to 1990. 



Lynch grew the fund from US$18 million to US$14 billion. He attracted investors by delivering an annual average return of a 28.2% during this time and charged high fees in return for his service. And boy, did he deliver. 

After years of looking for his successor, he finally chose his own lieutenant Morris Smith, who by the end of his first year, delivered the first negative return for the fund in a decade and a half. Morris quit after less than three years (despite a nice 32% return delivered in his second year). 

Jeffrey Vinik (1992 to 1996) and Robert Stansky (1996 to 2005) took over the fund in the years after Morris. And although these managers were amongst the highest qualified people to manage the Magellan fund, the returns in the 14 years after Peter Lynch were nothing compared to the returns he achieved. Magellan’s annual average performance in the 14 years after Lynch was of 13.2% (less than half of his). The fund never achieved the alpha delivered by Lynch.

So why did this happen? Some say Peter Lynch was lucky. I like to think he was a very smart manager, a highly skilled professional, with method and purpose. But since human cloning wasn’t an option, Lynch had the human task to teach someone everything he knew. 

And he failed. As great as Lynch was, he was unable to transfer his full set of skills to the company. And that’s ultimately, an inescapable issue for asset management companies.

Enter the machines 

I’d like to suggest that actively managed strategies aren’t flawed per se. It’s just that they are currently managed by humans. That’s all. 

Both the underperformance of most managers, and the impossibility of transferring all the necessary skills of successful managers to their successors, will push asset managers to embrace AI sooner than later. And when this happens, the trend of flows going into passive investments may well revert. 

Such transition will depend, of course, on the fees of the new actively managed funds, the accessibility of these types of investments to the broader community, the appropriate regulation supporting it, and the level of trust we’re willing to deposit into machines to take over our savings. It’s a technological shift as well as a cultural change.

If we consider what we’re capable of doing now, there are very few reasons to believe that active portfolio management will remain a human occupation by 2050 (or even before). Humans will likely continue to write code to develop AI, and people too will continue to teach their machines the basics of active investments, until they can learn it on their own... What’s clear is that the execution of an investment strategy will fall under the domain of machines.

In fact, this is already happening. 

Man Group has been actively researching Machine Learning techniques for a few years in collaboration with the University of Oxford. The company has also successfully applied Machine Learning models within its client trading programs (more on this here).

The human need for machines



Machines alone won’t push for this trend. After all, AI has been designed by humans to fulfil human needs. But consider the people who are involved in active investment funds. How many people do you know who want to be managing the same fund for two or three decades in a row? 

Best to leave that inhuman job to a machine with AI integrated. The AI won’t have headaches or feel tired. It won’t be worried about paying its mortgages or moved by the wrong incentives. AI will just perform its job, it will be delivering alpha, which is something humans can’t do very well. 


In asset management, like in other industries, change is inevitable. At Honner, by working along with companies who’re at the forefront of disruption in financial services, we understand this. 

Honner is part of the global alliance of PR companies in finance GFC / Net and the newly formed Global Fintech Network. If you’re company is ready to disrupt financial services and need communications support, contact us on honner@honner.com.au.



By Eric Robledo

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