As our modern technological revolution expands geometrically, it creates an existential challenge and opportunity to traditional industries. In a recent advertising video, a global investment management firm embraces this progress by saying “In our pockets, we now hold the ability to summon a car, monitor our health, and make a restaurant reservation. Advances in data and technology are driving innovation, bringing scale to reduce costs, and transforming our lives.”
As is our good fortune, the technology transformation boils down to greater choice and lower costs. Of course that’s how human ingenuity always works, investing money is no exception. In the 1970s, we saw the creation of low-cost index mutual funds. In the 1990s the internet brought us online, do-it-yourself stock trading platforms. The industry has seen a downward spiral in its commissions and fee structures, and a great expansion in the variety of services it offers to consumers. So what is happening now that is so transformational?
Appealing to the Technology Savvy Consumer
To be expected, it comes down to data and computing power delivering ease and reliability. At its core, the financial data scientists study the price fluctuations of millions of transactions in heavily traded securities markets. As economist and analyst Richard Salsman explains it:
We only use prices, not government and corporate accounting data or surveys. Only prices are established by the combined intelligence of all buyers and sellers at each point in time. Only prices represent forward-looking money on the line. By using only the hard-evidence of market prices, we uncover the most reliable, signaling price relationships amid markets and cycles.
This newfound respect for the price mechanism is, at least in part, a result of the economic and financial crises of 2008. Investors lost confidence in traditional investment management; and worse, they lost confidence in markets. According to this recent advertising video “We need a new way; factor investing can help. Powered by data and technology, coupled with fundamental investment ideas, that new way of investing may be here. But what are factors?”
An even better question is, why should I trust advertising? The tricky part is the use of the word new. It’s only new to the broader investment management industry. The ad goes on to explain. “Factors aren’t new, they’ve been around for decades. And are grounded in rigorous, Nobel Prize winning research. The innovation is not the investment ideas themselves, it’s in the way we access those investment ideas.”
Old Price Signals Uncovered by New Technology
To access the factors that drive investment performance requires a great deal of computing power. It also requires a massive amount of data about securities pricing, their volatility, and how they react to each other. For any asset manager to do this efficiently, they need the hardware and software that will allow them to create their factor based “smart beta” portfolios.
With the recent gains in computing power, and the rising demand for low-cost and reliable investment solutions, factor-based investing is finally gaining wide acceptance. According to the original Nobel prize winning research, the factors that deliver most of the market-wide returns are the market itself (stocks outperform bonds), price (stocks with low valuations), and size (small companies). Other factors include profitability, volatility, and momentum. According to the advertising video, factors are like nutrients to food – which nutrients to include depend on an investor’s financial well-being and spending goals.
One advantage of smart beta funds is to reduce an investor’s focus on beating some arbitrary stock or bond index. Another is to avoid the expense and underperformance risk of active managers whose only goal is to beat an arbitrary index that may not help their investors with their future cash flow needs. And for those of us who are not venture capital specialists, it helps us shift our focus to what really matters, living the one life we have.
Quantitative Investing Isn’t Pretty
Certainly there are risks; they don’t call factor based investing “smart-beta” for nothing. Beta means risk. And there are critics; for example analyst Steven Grey says correctly, “the artificial intelligence and machine learning employed by algorithms are very effective at identifying patterns imbedded in vast data sets. But the patterns ultimately reveal nothing about cause and effect.” And that’s fine, the price mechanism does. It aggregates millions of decisions made by millions of decision makers, all pursuing their own rational self-interest.
Grey also makes the point that “there is a reason why no private equity fund, LBO shop, or corporation has ever made an acquisition decision based on an algorithm.” But so what, that’s not who we are. Entrepreneurs create value with innovation, we create value by trading current consumption for future expected consumption. And the criticism that smart beta managers earn profits on superior trading efficiency ignores their very low volume of transactions, their reliance on efficient markets, and their patience in waiting for the best relative price possible. Another critique is that the only way for a smart beta managers to sustain a competitive advantage is for their data processing scientists to develop ever smarter algorithms. That assumes that a factor based quantitative analyst is only concerned with beating the market in the short-term, which is clearly not the case.
The inspiring development is that technology is able to harness the wonders of economic and political freedom, and the consequent price mechanism of capital markets, for very low cost. Perhaps economist Ludwig von Mises explained it best in his 1954 essay The Anti-Capitalist Mentality:
When modern industry began to provide the masses with the paraphernalia of a better life, their main concern was to produce as cheaply as possible without any regard to aesthetic values.
Regarding risk, an investor only has to abide by the very first factor identified by the financial scientists – the stock market itself. Managing our exposure to risk assets is a matter of freedom and choice.