Hu­man in­vestors still have the edge over ro­bots and al­go­rithms

Pretoria News Weekend - - OPINION - MARK APPLETON

THERE are myr­iad ap­proaches to in­vest­ing in var­i­ous as­set classes lo­cally or off­shore. In­vestors can choose of­fer­ings with pas­sive as­se­tal­lo­ca­tion tech­niques or ac­tive as­set-man­age­ment styles, or a com­bi­na­tion of the two.

At one end of the spec­trum is fun­da­men­tal ac­tive man­age­ment. Here hu­man judg­ment plays a large role in in­ter­pret­ing all the pub­licly avail­able in­for­ma­tion about an in­vest­ment. It could be qual­i­ta­tive, such as the trust­wor­thi­ness and com­pe­tence of a com­pany’s man­age­ment, or quan­ti­ta­tive – for ex­am­ple, look­ing at a com­pany’s fi­nan­cial re­sults. Ei­ther way, the fo­cus is on de­ter­min­ing the mer­its of a po­ten­tial in­vest­ment.

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 against the back­drop of a con­stantly evolv­ing macro en­vi­ron­ment and any mis­pric­ing of in­stru­ments within as­set 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.

At the other end of the spec­trum are pas­sive in­vest­ment ve­hi­cles that mimic mar­ket in­dices.

There are also quan­ti­ta­tively de­ter­mined pas­sive in­vest­ments, such as smart-beta funds, which use al­ter­na­tive in­dex-construction rules that take into ac­count fac­tors such as size, value and volatil­ity.

There are two spe­cific ad­van­tages to us­ing a pas­sive in­vest­ment ve­hi­cle: it tends to be rel­a­tively low cost, and it elim­i­nates the pos­si­bil­ity of un­der­per­form­ing a bench­mark.

Al­though they may seem to be com­pletely dif­fer­ent, ac­tive and pas­sive in­vest­ment ve­hi­cles are fun­da­men­tally linked. In fact, pas­sive in­vest­ment ve­hi­cles can­not ex­ist with­out ac­tive man­agers making mar­ket-mov­ing calls on what and when to buy or sell. Pas­sive in­vest­ments, in turn, can be ac­tively man­aged or in­cor­po­rated as part of an ac­tive port­fo­lioman­age­ment strat­egy.

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 (ETF), in a bal­anced, ac­tively man­aged port­fo­lio with other in­stru­ments, such as stand-alone shares.

Glob­ally, pas­sive strate­gies have seen a pick-up in fund flows, par­tic­u­larly 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.

One could ar­gue that the hu­man ac­tive man­ager still has the edge over the ro­bots. The ar­eas in which this is the case in­clude:

• As part of the ac­tive-man­age­ment process, an­a­lysts will have contact with the man­age­ment teams of the com­pa­nies in which they are look­ing to in­vest, or in which they are in­vested. This can be one-on-one, in smaller groups, on con­fer­ence calls, or in a larger au­di­ence at com­pany re­sults pre­sen­ta­tions.

Analysing hu­man be­hav­iour.

Man­agers tend to talk a good talk, and the abil­ity to pick up on little cues – even some­thing as triv­ial as man­age­ment “tone” – can be quite 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 down­ward. It has also been proved that the mar­ket re­acts to the use of neg­a­tive words in earn­ings re­leases, ac­cord­ing to a 2011 pa­per ti­tled “When is a li­a­bil­ity not a li­a­bil­ity?” by Tim Loughran and Bill McDon­ald.

Mo­ral and eth­i­cal con­sid­er­a­tions.

Since al­go­rithms typ­i­cally di­gest only nu­mer­i­cal in­for­ma­tion, a com­puter can­not ef­fec­tively grasp the trend to­wards re­spon­si­ble in­vest­ing.

Al­though the hard num­bers can be an­a­lysed with more vigour, ma­chines fall short when it comes to the softer 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 look­ing for cer­tainty in man­age­ment in­tent and an as­sur­ance that ESG fac­tors are prop­erly an­a­lysed and ac­counted for when making in­vest­ment de­ci­sions.

• Al­go­rithms typ­i­cally use his­tor­i­cal in­for­ma­tion to make an as­sess­ment of fu­ture re­turns (in this case, the de­pen­dent vari­able). This is based on the lev­els or move­ments of one or more in­de­pen­dent vari­ables – for ex­am­ple, gross do­mes­tic prod­uct growth, the ex­change rate and

Look­ing to the fu­ture.

val­u­a­tions. The hu­man ac­tive man­ager also tends to look closely at his­tory, making rea­son­able pre­dic­tions about how changes over time could give him or her a com­pet­i­tive edge.

The­matic in­vest­ing is also a re­cent ad­di­tion to the as­set­man­age­ment space. Mega themes, such as glob­al­i­sa­tion, a more con­nected so­ci­ety, the im­pact of re­source scarcity and ris­ing rates of obe­sity, can be as­sessed and con­sid­ered when choos­ing stocks, in­stru­ments or mar­kets that have ex­po­sure to such themes.

In the evolv­ing world of ro­bot­ics, it is im­por­tant to note that in­vest­ment is both an art and a sci­ence. It is in the art of in­vest­ing that the robo ap­proach may well be found lack­ing. Mark Appleton is the South African head of multi as­set and strat­egy at Ash­bur­ton In­vest­ments.

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