Modern investing merges human insight with robo efficiency, causing some to argue that the role of the human advisor is dwindling. But human judgement still has a vital role to play in active and passive investment strategies.
There are myriad different approaches to investing in various asset classes, be it locally or offshore. Potential investors can choose offerings with passive asset allocation techniques or active asset management styles, or even a combination of the two.
On the one end of the scale lies fundamental active management. Here human judgement plays a large role in interpreting all publically available information about an investment. It could be qualitative (such as trustworthiness and competence of company management) or quantitative (for instance looking at the financial results of a company). Either way, the focus is on determining the relative investment merits of the potential investment in question. 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 themselves against a backdrop of a constantly evolving macro environment and any mispricing of instruments within these 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.
On the other end are passive investment vehicles that mimic various market indexes.
There are also quantitatively determined passive investments such as smart beta, which uses alternative index construction rules taking into account factors such as size, value and volatility.
There are two specific advantages to utilising a passive investment vehicle. Firstly, it tends to be relatively low cost and eliminates the possibility of underperforming a benchmark (since it tracks that benchmark, effectively removing both alpha and beta from the equation).
Although they may seem like different worlds, 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 also be actively asset managed or incorporated as part of an active portfolio management strategy.
Active-passive strategies may include utilising specific asset class trackers as building blocks in an asset allocation strategy, or incorporating specific passive instruments – like an offshore exchange-traded fund (ETF) for example – in a balanced actively managed portfolio with other instruments (like stand-alone stocks).
Globally passive strategies have seen a pick-up in fund flows, especially 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 where robo-advisors and algorithms can make asset allocation and even instrument selection decisions for funds and portfolios.
In fact, one could argue that the human active manager still has the edge over the robots.
Analysing human behaviour
As part of the active management process, analysts will have contact with the management teams of companies they are looking to invest in (or are invested in). This can be one-on-one, in smaller groups, on conference calls, or in a larger audience at company results presentations. Managers tend to talk a good talk and the ability to pick up on little cues – even something as silly 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 proven that the market reacts to the use of negative words in earnings releases, according to a 2011 paper entitled When is a liability not a liability? by Tim Loughran and Bill McDonald.
Moral and ethical considerations
Since algorithms typically digest only numerical information, the trend towards responsible investing cannot yet be effectively grasped by a computer. While the hard numbers can certainly be analysed with more vigour, the 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.
Looking to the future
Algorithms typically use historic 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, or valuations). While the human active manager also tends to look at history very closely, making reasonable predictions about how the world may change over time can give him or her a competitive edge. Thematic investing is also a recent addition to the asset management space. Mega themes like globalisation, a more connected society, the impact of the resource scarcity, or rising obesity can be assessed and considered when choosing stocks, instruments, or markets which have exposure to such themes.
In the modern and evolving world of robotics it is important to note that investment is both an art and a science. This remains the preserve of human advisors since it is in the ‘art’ of investing that the robo approach may well be found lacking.
“Managers tend to talk a good talk and the ability to pick up on little cues – even something as silly as management ‘tone’ – can be quite telling.”