Why human advisers still trump machines in investment world
Computers may crunch the numbers, but it is flesh and blood that interpret the figures
Modern investing merges human insight with robotic efficiency, prompting some to argue that the influence of the human adviser is dwindling. But human judgment still has a vital role to play in investment strategies.
There are myriad different approaches to investing in various asset classes, be it locally or offshore. Potential investors can choose offerings with passive asset allocation techniques or active asset management styles, or even a combination of both.
On the one end of the scale lies fundamental active management. Here human judgment plays a large role in interpreting all publicly available information about an investment.
It could be qualitative (such as trustworthiness and competence of company management) or quantitative (for instance, looking at the financial results of a company).
Either way, the focus is on determining the relative investment merits of the potential investment in question. Risk and cross-correlations also come into the equation when constructing an efficient actively managed portfolio.
Active asset management seeks to take advantage of the changing investment merits of asset classes themselves against a backdrop of a constantly evolving macro environment and any mispricing of instruments within these classes.
It often also incorporates risk assessment — ensuring that undue risk is not taken in chasing returns. Within this framework, active managers aim to deliver alpha (above-market returns) to investors.
On the other end are passive investment vehicles that mimic various market indices. There are also quantitatively determined passive investments such as smart beta, which uses alternative index construction rules taking into account factors such as size, value and volatility.
Using a passive investment vehicle has two advantages. First, they tend to be relatively low cost and eliminate the possibility of underperforming benchmarks, since they track those benchmarks, effectively removing alpha and beta from the equation.
Although they may seem like different worlds, active and passive investment vehicles are fundamentally linked. In fact, passive investment vehicles cannot exist without active managers making marketmoving calls on what and when to buy or sell. Passive investments, in turn, can also be actively asset-managed or incorporated as part of an active portfolio management strategy.
HUMAN MANAGERS
Active-passive strategies may include using specific asset class trackers as building blocks in an asset allocation strategy, or incorporating specific passive instruments — such as an offshore exchange-traded fund — in a balanced actively managed portfolio with other instruments, such as stand-alone stocks.
Globally passive strategies have experienced a pick-up in fund flows, especially in more efficient developed markets where alpha has become more difficult to come by.
This has deeper implications for human active managers, who clearly still have a role to play in the modern world of investing, despite the fact that we are living in a time when robo-advisers and algorithms can make asset allocation and even instrument selection decisions for funds and portfolios.
In fact, one could argue that the human active manager still has the edge over the robots. These include:
Analysing human behaviour. As part of the active management process, analysts will have contact with the management teams of companies they are looking to invest in (or are invested in).
This can be one on one, in smaller groups, on conference calls, or in a larger audience at company results presentations. Managers tend to talk a good talk and the ability to pick up on little cues — even something as silly as management “tone” — can be telling.
In a 2016 Harvard Kennedy School white paper (Reading Managerial Tone: How Analysts and the Market Respond to Conference Calls), Marina Druz, Alexander Wagner and Richard Zeckhauser assert that a negative tone on conference calls results in stock prices drifting downwards. It has also been proven that the market reacts to the use of negative words in earnings releases, according to a 2011 paper by Tim Loughran and Bill McDonald.
Moral and ethical considerations. Since algorithms typically digest only numerical information, the trend towards responsible investing cannot be effectively grasped by a computer. While the hard numbers can certainly be analysed with more vigour, the machines fall short when it comes to the softer, nuanced issues.
Incorporating environmental, social and governance (ESG) considerations in the investment process, identifying “funny” accounting, and the assessment of management intent still require human interpretation.
In recent years, investors have begun to demand a more ethical approach to investing. They are increasingly looking for certainty in management intent and an assurance that ESG factors are properly analysed and accounted for when making investment decisions.
Looking to the future. Algorithms typically use historic information to make an assessment of future returns, in this case the dependent variable. His is based on the levels or movements of one or more independent variables, for example, GDP growth, the exchange rate, or valuations. While the human active manager also tends to look at history very closely, making reasonable predictions about how the world may change over time can give him or her a competitive edge.
Thematic investing is also a recent addition to the asset management space.
Megathemes such as globalisation, a more connected society, the effect of resource scarcity or rising obesity can be assessed and considered when choosing stocks, instruments or markets that have exposure to such themes.
In the modern and evolving world of robotics it is important to note that investment is an art and a science. This remains the preserve of human advisers since it is in the “art” of investing that the robo-approach may well be found lacking.
MANAGERS TEND TO TALK A GOOD TALK AND THE ABILITY TO PICK UP ON LITTLE CUES CAN BE TELLING