Man vs machine: Managing your investment risk for the future

Written by By Roland Rousseau, Head of Barclays Risk Strategy Group • Online since 31.08.2016 • Filed under Industry news • From Issue 4 - September 2016 - February 2017 page(s) 47-48
Man vs machine: Managing your investment risk for the future

Technological advances are disrupting business models in various sectors around the world, and the investment industry is no exception.

At the annual Eastern and Southern Africa Pension Fund Conference held in Botswana earlier this year, the role of technology in assessing and managing risk was hotly debated. The investment industry has reached a new era that can be compared to the Information Age when technology bolsters human processing power, providing more insight into investment risks than previously possible. In this new era, successful fund managers will be those who harness technology to cut costs and manage investors’ multidimensional risks. They will be guided by analytical tools rather than by subjective opinion.

In the past, markets were deemed to be rational and efficient. Today, research increasingly highlights that markets are biased by human irrationality and that major crashes are much more likely to occur than rational market expectations assume. As a consequence – given the 1998 Emerging Market crisis, the 2000 Tech bubble, and the 2008 Financial Crisis – the latest research now shows that the investment industry has not always managed clients’ risk effectively. Both active and passive investing focused on returns and costs, not on risk.

Traditional tracking

The latest findings demonstrate that by trying to beat benchmarks, traditional active management has, in many cases, resulted in higher risk, inflated costs and what economists call principal-agent conflicts (ie fund managers only participate in gains, not in investors’ downside).Similarly, research now also shows that traditional passive tracking of the market has indeed lowered fees for investors but certainly has not effectively reduced risk from all their portfolios. Equity markets are even more highly concentrated with nearly 50% of the total value contained in five to ten stocks in South Africa. Tracking the market index is far from buying a well-diversified portfolio.

Data-savvy technology

The investment management industry is finally entering a period where risk management is recognised as the central purpose of delivering value to clients. Markets are driven much more by non-financial and non-economic data than previously thought. For example, some data-savvy technologists can already predict earnings growth for a large listed company, long before the company selling the goods even knows. By monitoring the searches from search engines such as Google, and tracking online sales from vendors such as Amazon, we can get a detailed head start about which products are selling the fastest right now and which companies will triumph over their competitors, long before the earnings reports are audited and made public.

The future of effective risk management lies with those who invest in analytical tools to analyse big data and monitor changes to risk appetite. We expect major disruption for existing fund management businesses that still rely on traditional valuation models and subjective decision-making, using stale financial or economic data. The Nobel Prize winner, Eugene Fama, famously demonstrated that more than 80% of excess portfolio returns are due to excess risks and not fund manager skill. In fact, it is not difficult to show that good risk management, coupled with lower returns (eg minimising exposure to crises), is better for long-term wealth generation than trying to do the impossible by constantly attempting to beat benchmarks through higher risk.

Fund managers of the future

Given the above considerations, who today is managing your investment risk in your best interest? We have demonstrated that neither traditional active management, nor standard passive market tracking is adept at doing what end-investors really, really need. It was clear during the conference in Botswana that the investment industry is now coming to terms with this changing landscape. Those who will survive this shift will leverage a very different approach than in the past. The fund managers of the future will not try to outperform their peers, nor maximise your returns by delivering excess risk in a zero-sum game. Instead, they will be rewarded for aligning their interests with your interests. Their skill will be demonstrated not by outperforming arbitrary benchmarks, but by leveraging technology to lower investment costs and removing unnecessary risk from your portfolio, growing your wealth more efficiently.

Issue 4 - September 2016 - February 2017

Issue 4 - September 2016 - February 2017

This article was featured on page 47-48 of SABI Magazine Issue 4 - September 2016 - February 2017 .

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