Automatic Investing and the Future of Computers on Wall Street
Human bankers on wall street are about to discover that they are no longer the smartest guys in the room. On the surface, the challenges that today’s markets face seem to be revolving around the ideas of a trade war or low interest rates, but an issue which is not being considered enough is that of a full computer take-over in the world of finance. Machines are taking control of investing – that is, investing on all levels. Ranging from the selling and buying of securities to the monitoring of the economy and the strict allocation of capital. Artificial Intelligence algorithms are also starting to write their own investing rules and guidelines, while simultaneously following the ones set by their human monitors.
Currently, funds run by computers under human set investment guidelines account for over 35% of the American stock market, 60% of trading activity and 60% of institutional equity assets. An example is exchange traded funds (ETF’s) and mutual funds which automatically track indices of shares and bonds. On September 13th 2019, these vehicles had $4.3 trn invested in American equities, a sum which exceeded any investment done by humans in the past.
Fifty years ago, investing was all about the people. “People would have to take each other out, dealers would entertain fund managers, and nobody would know what the prices were” says Ray Dalio, NYSE investor and founder of Bridgewater Associates, the world’s largest hedge fund. But since then, the role of humans in trading has reversed. The rise of financial robotization is not only changing the speed and shape of the stock market but is also raising questions about the impacts of markets on the wider economy, the corporate governance of companies, the functions of markets and the overall market stability.
But algorithms are nothing new in portfolio management. In 1975 Jack Bogle founded Vanguard, which was responsible for creating the first index fund thus automating simple portfolio allocation. By the 1980’s and 1990’s, quantitative (quant) hedge funds and exchange traded funds (ETF’s) emerged. These algorithms managed what was called ‘factors’, or in other words, the traits used for scouring of market data and hunting for stocks.
These machine investors are constantly changing. Some quant funds like Bridgewater, use algorithms to simply perform data analysis while human investors select trades. On the other hand, other quant funds such as Two Sigma and Renaissance Technologies are using machine learning and artificial intelligence to enable the machines to pick which stocks to buy and sell. The more prominent question now is whether computers will ultimately take over investors’ main job; analysing information in order to design investment strategies.
According to Deutsche bank, 90% of equity-futures trades and 80% of cash equity trades are executed solely by algorithms with no human input whatsoever.
Quant funds can generally be divided into two groups, through a division very similar to that of AI; those which use machines to mimic human strategies and follow human-programmed investment rules, and those which use machines that create strategies themselves, much like Google’s AlphaZero.
The total value of American equities is $31 trn. The three types of computer managed funds – quant funds, index funds and ETF funds – manage around 35% of this entire number while traditional hedge funds and mutual funds manage only 24% (the remainder are difficult to calculate).
The result is that the stock market is now more efficient than it ever has been through lower costs. Passive funds charge 0.03 – 0.09% of assets under management annually, a much lower number than active managers and hedge funds which charge twenty times that number.
As any major emerging development, the era of machine-dominated finance raises worries. Computers can distort asset prices as many algorithms can chase securities with a specific characteristic and then suddenly abandon them. Regulators are worried that once markets fall, liquidity evaporates. “Flash Crashes” are something which investors are particularly worried about when it comes to the full incorporation of computers within investment banking. In 2010, more than 5% of the value of the S&P was wiped in a matter of minutes, and similarly in 2014 where 5% of bond prices rallied sharply in, again, a matter of minutes. The markets had more or less normalized by the end of the day in both those cases however the shallowness of liquidity by high-frequency traders became under investigation by regulators.
But human investors are not out of a job yet, there is still the need for somebody to feed the correct data into the machine. It is no secret that technology is changing Wall Street and Investment banking as we know it.
Ellie Nikolova