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Fintech disruption in asset management – man versus machine

23 January 2018Mark Lindhiem, Alexander Forbes Investments
Mark Lindhiem, Head of Strategy at Alexander Forbes Investments.

Mark Lindhiem, Head of Strategy at Alexander Forbes Investments.

One of the first big events on the global calendar is the annual World Economic Forum in Davos. This year’s theme “Creating a Shared Future in a Fractured World” focuses on making a renewed commitment to international collaboration to solve critical global political, economic and social issues. Among the many and varied agendas, the concept of the Fourth Industrial Revolution will be top of mind for many. One of the key areas of interest in this regard is considering how the future of Artificial Intelligence (AI) and automation will affect the financial and monetary system.

News items about technology disruption in some industries appear daily, but what about the fund/asset management industry? You have to look a bit harder, but it is there under the banner “fintech”. Increasingly we are hearing about technology-led developments in the South African fund/asset management space. There has been some publicity about robo-advisers, a class of financial adviser providing digital financial advice based on algorithms, with moderate to minimal human intervention. However, very little has been written about the actual management of money through AI and machine learning, certainly in the South African environment.

Asset managers are supportive of and are investing in the technology revolution, but for some reason the vast majority believe their professional endeavor – mostly stock selection – will not be disrupted by innovative technology. As the largest asset manager researchers and selectors in Africa, we at Alexander Forbes Investments are simply not seeing asset managers embrace the tech revolution fast enough, or even at all. One of the reasons can likely be ascribed to the quote from Greek philosopher Epictetus, who said: “It is impossible to begin to learn that which one thinks one already knows.” Fund managers may, sooner than they think, wake up to a new and harsh reality. The fund management industry is steeped in decades of operating a certain way, based on academic theories and learnings (some of which may be outdated or invalid), and entrenched human experience. Well, change has arrived and is banging loudly on the door. Fund managers who don’t adapt quickly will find it hard to survive.

The broad premise of active fund management over the decades has been simple – manage money to beat an index or other measure, and charge a reasonable fee, commensurate with the value being added. However, the industry has, on average, not achieved this objective and the fees charged, even where there has been value added, consume much of the value. Couple this with fintech advancements and it describes an industry ripe for disruption.

With increased and real time access to information, customer scrutiny becomes a threat to active fund managers who are not delivering value at a reasonable fee. In addition, with the advent of a wide variety of passive and quasi-passive funds across and within asset classes, investors can now build their investment strategies more cost effectively, while still managing for risk.

The allure of active fund management is linked to the psychology of investor behaviour, which is often simplistically described as the hope (possibly greed) to maximise wealth, or the fear of losing out or losing money. Unfortunately, humans are all wired with this built-in bias, which can lead us to make poor investment decisions, such as chasing past performance and/or selling out after a market correction for fear of losing more money. The recent Steinhoff scandal is a great case in point. No doubt some of the supposedly better fund managers got caught holding the popular Steinhoff shares for fear of underperforming their peers, or the index, even when some doubt lingered.

To make matters worse, even if an active fund manager has added value over time, many of their clients will at some time or other have switched investments and not stayed the course. Thus, the returns the good fund managers deliver do not unfortunately equate to what most investors receive. The industry has been quite poor at helping clients overcome these value-destroying behavioural tendencies. We have paid too little attention to ensuring our clients have the right experience, which would lead them to better decision making.

Fund managers across the board should perform an honest self-assessment and ask how they are delivering value to their clients. If they are not sustainably beating their benchmarks (after fees) over time, they need to make material changes to how the money is managed (hint: look to technology to help you), or find an alternate profession. This may sound harsh but the question is not if their clients will leave them, but when their clients will leave them – probably sooner than they think.

With significant fintech advancements coming our way, and given how technology is increasingly dominating our lives, businesses that do not embrace it will be left behind - regardless of the value they currently deliver for clients. Aside from the disruptive element, technology is also scalable and thus helps reduce costs to enable fund managers to lower their fees, which can directly benefit clients through better net investment returns.

Moore’s Law states that computing power doubles approximately every 18 months, and that this trend of exponential growth will continue into the foreseeable future. With the advent of a Moore’s Law type advancement in machine learning and AI, the threat to existing players in the financial services sector who don’t evolve is acute. Fintech will bring increased operational and cost efficiencies to the middle and back office functions through innovations such as blockchain. But the real disruption will occur in the front office, in the way money is managed, as AI and machine learning advance in the coming years. A large part of poor investor decision making can be explained by natural human behavioural biases, which machine learning algorithms do not exhibit. This is evidenced by a characteristic shared by some of the most successful global management firms, who for decades have used technology and algorithms to successfully help them make better investment decisions for their clients.

In the South African market we have seen the recent launch of the first machine learning unit trust, managed by NMRQL Research, which is the first machine learning company in the local fund management industry. Of course certain technologies and technological methods (algorithms) will be better than others, and there will be failures along the way, but this is where new competition will come into being. And there are areas where computers may not be superior to humans, such as when dealing with ambiguity and relationship building. But, in time, these areas too may well be mastered by smart technology.

Fund management firms who embrace technology to innovate and reduce costs and fees, and those who place greater emphasis on delivering value as defined by the customer, will have a greater chance of surviving and thriving in this exciting but uncertain future dominated by progressive technological advancements. The power in the new world relies on man embracing the machine.

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