Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 240

AI and an intelligent active manager’s odyssey

In spite of Artificial Intelligence's (AI) transformative potential, the investment management industry has been slow to invest in and use AI compared with other developed industries. This paper explores the journey of AI, a threat to active management that comes quickly behind the current shift to passive investment strategies.

Active management and the demand for hope

Much ink and some blood has been spilt over passive Exchange Traded Fund’s (ETF) supposed existential threat to the active management of securities and assets. While roughly one-third of all global equity management is now passive, the threat itself is overstated. Active’s survival, though in a much reduced form, is assured by the eternal demand for hope – hope of beating the market, hope of being above average, hope of not missing out. Supply to meet that demand flows willingly from active managers’ engaging and sometimes insightful narratives about exciting stocks, often hyped by new technologies.

That said, active is exposed to a deeper and longer-term threat, one that might just ‘sweep it away’. The Greek C P Cafavy’s poem Things Ended highlights how easily we miss more damaging threats:

Engulfed by fear and suspicion,

mind agitated, eyes alarmed

we try desperately to invent ways out,

plan how to avoid the obvious danger

that threatens us so terribly.

Yet we’re mistaken, that’s not the danger ahead:

the news was wrong

(or we didn’t hear it, or didn’t get it right).

Another disaster, one we never imagined,

suddenly, violently descends upon us,

and finding us unprepared – there’s no time now –

sweeps us away.

The opening gambit is Blackrock’s intention to replace all or many or some traditional active equity processes (of which Blackrock has $300 billion in assets under management) with quantitative active processes ostensibly because quant can generate alpha as successfully as traditional and at far lower cost. For many this is an old story. Most traditional managers rely on some form of computer-driven quant processes in portfolio construction and trading. Since 2010, the assets of quant hedge funds has doubled to nearly US$1 trillion, while according to JPMorgan, orders placed by computers now account for 60% of US trading volume, double the figure from a decade earlier. However, scale and market presence threaten to transform Blackrock’s initiative into an imperative for traditional managers.

A more substantial threat is lurking: Artificial Intelligence

But ‘going quant’ will provide only short-term solace. Lurking under the rubric ‘quant’ lies the more substantial threat of Artificial Intelligence (AI) or Deep Machine Learning.

The threat of AI to routine process-driven jobs is manifest even after discounting the considerable hype. But AI also threatens the jobs of lawyers, radiologists and others demanding advanced cognitive skills with its ability to recognise patterns and images, to learn, to improve its own algorithms.

In the investment management industry, both back and front offices are threatened. Eventually, AI will probably be capable of ‘thinking’ about, crafting, writing and even delivering engaging, insightful and empathetic narratives. Some AI programs already pass Turing’s Test in which interlocutors fail to distinguish between answers from a human and a computer.

Then AI too will sell hope.

Is this scenario, the ultimate disruptive one where machines make (almost) all investment and commercial decisions, pitch for business and report to clients? Or does it belong in the SciFi fantasy world? Doubtless some is fantasy, but less than we might hope for.

We tend to overestimate the short-term effects of new technology while underestimating the long-term effects. Campbell Harvey, a respected finance professor predicts that “in the end it will be a good thing for investors” if human judgement is usurped by machine judgement. When Amazon enters investment management that harsh reality may well emerge from picturesque fantasy. Indeed, Autonomous Learning Investment Strategies (ALIS) have been with us for some time though as yet they are not capable of crafting new insights or of selling hope.

AI’s co-existence with active managers

The history of technology suggests that some form of traditional active management will survive the rise of machines. The new often co-exists with the old rather than fully replacing it … quills and slide-rules notwithstanding. Co-existence will advance through human-machine interaction where human and machine in turn leverage off the other’s insights in a process of continual improvement. To thrive in that world active managers will need as yet unknown skills.

For a while at least, a traditional active approach should thrive. Traditional is likely to outperform machines in managing highly-concentrated portfolios and alternative assets, especially in heterogeneous domains where idiosyncratic risk is high and tacit security-specific knowledge is critical. To the extent that AI learns through data-mining, the relative scarcity of data in those domains favours humans.

Further, much alternative investing lacks robust, predictive theories which again favours human minds. However, both advantages will likely fade as AI overtakes the human ability to develop intuitive knowledge and insights without much data and without theories. When machines can formulate and test their own explanatory hypotheses traditional active management will raise the white flag. That fearful scenario lies ahead, as currently AI/Deep Machine Learning is poor at generalising specific information and can’t provide explanations or reasons to justify or explain its decisions (see ‘The dark secret at the heart of AI, MIT Technology Review, May/June 2017).

Currently it is a very black black-box and even blacker than the black-box inside active managers’ heads. The world chess champion Alpha Zero, given only the rules and aim of the game, learns to play chess by playing against itself many times, but can’t explain or justify its moves and tactics.

Investment management slow to invest in AI

In spite of AI’s transformative potential, the investment management industry has been slow to invest in the necessary R&D, and even slower to use AI compared with other developed industries. Investing fails to rate a mention in Stanford University’s AI Index. Failure is likely explained by the comfort induced by persistently high margins, by the industry’s capital-light structure which inhibits capital-intensive R&D, and by its much-vaunted essence as a human relationship-driven business. If Blackrock’s initiative drives lower margins, it may encourage the development of AI in active investment management. Further, the rules under MiFID II may cause an easy target as sell-side analysts become ‘AI’d’.).

Embracing the opportunity

Unsurprisingly, some hedge funds with their greater institutional and intellectual freedom have been early adopters of AI and not just to uncover previously hidden factors in capital markets but also to improve human insights and decisions. The CFA has taken a positive step by offering teaching modules in AI and Big Data. Perhaps that’s a straw in the wind. Perhaps the investment industry will sacrifice its long-protected comfort and embrace the opportunity and risks afforded by on-going advances in Artificial Intelligence and Deep Machine Learning.

 

Jack Gray is a Special Advisor and Director of Brookvine. Jack has been voted one of the Top 10 most influential academics (in his previous life as an academic) in the world for institutional investing.

banner

Most viewed in recent weeks

Australian stocks will crush housing over the next decade, one year on

Last year, I wrote an article suggesting returns from ASX stocks would trample those from housing over the next decade. One year later, this is an update on how that forecast is going and what's changed since.

What to expect from the Australian property market in 2025

The housing market was subdued in 2024, and pessimism abounds as we start the new year. 2025 is likely to be a tale of two halves, with interest rate cuts fuelling a resurgence in buyer demand in the second half of the year.

The perfect portfolio for the next decade

This examines the performance of key asset classes and sub-sectors in 2024 and over longer timeframes, and the lessons that can be drawn for constructing an investment portfolio for the next decade.

Howard Marks warns of market froth

The renowned investor has penned his first investor letter for 2025 and it’s a ripper. He runs through what bubbles are, which ones he’s experienced, and whether today’s markets qualify as the third major bubble of this century.

9 lessons from 2024

Key lessons include expensive stocks can always get more expensive, Bitcoin is our tulip mania, follow the smart money, the young are coming with pitchforks on housing, and the importance of staying invested.

The 20 most popular articles of 2024

Check out the most-read Firstlinks articles from 2024. From '16 ASX stocks to buy and hold forever', to 'The best strategy to build income for life', and 'Where baby boomer wealth will end up', there's something for all.

Latest Updates

Investment strategies

The perfect portfolio for the next decade

This examines the performance of key asset classes and sub-sectors in 2024 and over longer timeframes, and the lessons that can be drawn for constructing an investment portfolio for the next decade.

Shares

The case for and against US stock market exceptionalism

The outlook for equities in 2025 has been dominated by one question: will the US market's supremacy continue? Whichever side of the debate you sit on, you should challenge yourself by considering the alternative.

Taxation

Negative gearing: is it a tax concession?

Negative gearing allows investors to deduct rental property expenses, including interest, from taxable income, but its tax concession status is debatable. The real issue lies in the favorable tax treatment of capital gains. 

Investing

How can you not be bullish the US?

Trump's election has turbocharged US equities, but can that outperformance continue? Expensive valuations, rising bond yields, and a potential narrowing of EPS growth versus the rest of the world, are risks.

Planning

Navigating broken relationships and untangling assets

Untangling assets after a broken relationship can be daunting. But approaching the situation fully informed, in good health and with open communication can make the process more manageable and less costly.

Beware the bond vigilantes in Australia

Unlike their peers in the US and UK, policy makers in Australia haven't faced a bond market rebellion in recent times. This could change if current levels of issuance at the state and territory level continue.

Retirement

What you need to know about retirement village contracts

Retirement village contracts often require significant upfront payments, with residents losing control over their money. While they may offer a '100% share in capital gain', it's important to look at the numbers before committing.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.