If almost nothing else of note had occurred in 2016, the events of Nov. 8 would still have made it a watershed year for markets and managers. The immediate question is: “Now what?”
As our team at Axioma gathered to ponder this matter, at least in terms of the election, one thing became clear: No one really has a clue — at Axioma or anywhere else, for that matter. So rather than speculate on what we don't know, let's consider what we do know. And at least one thing is certain: most of 2016 was a tough year for active managers, and 2017 is unlikely to be any easier.
That said, here's our list of eight items that — the actions of the president-elect notwithstanding — are likely to shape the investment landscape in 2017.
As Alice might have observed, things are getting “quantier and quantier.”
More and more portfolio managers are adding quant tools to their investment processes, and for three main reasons. First, many have realized that it's the unintended risks — things quant tools happen to be excellent at detecting — that hurt their performance more than anything else. Second, as asset owners become increasingly sophisticated, they are demanding quant measures and analytics from their asset managers, and non-compliance is not an option. And third, as asset owners shift their focus to factor investing, quantitative tools become even more relevant and ubiquitous.
Just how smart, and how beta, is your smart beta?
Axioma took a close look at these popular strategies in 2016 and what we discovered is that many products vigorously marketed as smart beta are often neither smart nor beta.
Let's be explicitly clear on one point: smart beta strategies are supposed to be quant strategies, but many smart beta manufacturers sacrificed portfolio construction techniques for “simplicity.” So look for quants to come to the rescue of smart beta next year, bringing discipline and focus to the portfolio-construction process. The result will be smart beta products that truly represent the intent of a given product, while also delivering greater efficiency in terms of transaction costs and market impact, thus avoiding drag. And with improved portfolio construction, smart beta will be more immune to sudden market moves that affect performance, including the effects of crowding.
We're here for the big MACs.
Multiasset-class investing is increasing and will continue to do so in 2017. Investors want the flexibility and diversification that MAC portfolios deliver. One important distinction: We are talking here about MAC portfolios constructed from the top down, i.e., built to meet specifically defined factor exposures and characteristics by selecting assets in different asset classes to ensure true diversification. In 2017, we'll continue to see the proliferation of multiasset-class liquid instruments that further facilitate the construction of such portfolios, such as ETFs.
- The analytics arms race is on. Thanks to the proliferation of multiasset-class investing cited above, the individual asset classes that once provided automatic portfolio diversification are becoming more interconnected. More connections mean increased interaction, which leads to increased correlations among those asset classes. And the only way for asset managers to understand and capitalize on those complex dynamics — call it factor investing — is with mathematical models and heavy-duty analytics. Multiasset-class investing is triggering an analytics arms race, the scope of which few grasp, and even fewer are equipping themselves to meet.
- How to pick the right weapon. Yes, portfolio managers need analytics, but in an environment brimming with tools, how do you identify those that are relevant to your process and needs? Enter smart analytics, which utilize machine learning to pinpoint the analytics that are right for your investment process. While the concept of smart analytics is not on many radar screens at the moment, we expect it to be a significant emerging theme in 2017.
Got a hunch? We prefer technology and data, thank you.
With a majority of active U.S. stock mutual funds underperforming against index funds, investors are justifiably asking, “Why pay for actively managed strategies?” For worried asset managers, technology and data have the potential to enable them to turn things around. Machine learning, data visualization, artificial intelligence, natural-language processing and predictive reasoning are just some of the technologies and tools now being harnessed by a small but growing cadre of alternative managers. Industry research firm Forrester calls 2017 the year of the “insights revolution,” driven in part by artificial intelligence. AI will extend to deep learning to build cutting-edge investment systems. As reported by the Financial Times, “Big, established asset managers and hedge funds … are pouring money into technology and data management, snapping up computer scientists to help them build and develop next-generation investment systems that can outperform any human.” Hasta la vista, baby.
The forecast calls for the cloud.
A recent report by PricewaterhouseCoopers said 52% of asset management CEOs believe cloud computing is strategically vital to the futures of their organizations. While much of current cloud usage involves non-core activities, 2017 will witness a major migration of essential investment-related business activity to the cloud. The goal? To leverage the scalability and elasticity of cloud computing in order to maintain performance in what is likely to be another challenging year. By the way, the need for cloud computing ties right into the analytics arms race. The ability to react to sudden market swings of the sort we have witnessed in recent years — flash crashes, etc. — means analytics must be crunched quickly. The on-demand, scalable computing power of the cloud is critical to that need because even the biggest proprietary data center will face challenges at peak usage. And let's not forget that the cloud continually leverages the latest in technology, security and reliability, while reducing total costs of ownership.
Everybody toe that regulatory (and risk) line!
The Department of Labor's April 2016 final fiduciary rule outlined new guidelines for managers, aimed at eliminating any potential conflicts of interest regarding retirement advice. Add to that the impact of the SEC's Modernization Rule, and managers face significant additional compliance requirements. So demonstrating transparency and value will be even more important in 2017. All of this, by the way, speaks to the increasing convergence of risk and regulatory reporting. Consistency when talking about risk — from the front, to the middle, to the back office — is now a de facto requirement.
This is the dawning of the Age of Millennials.
Millennials are now the largest living demographic. While baby boomers still hold the majority of U.S. wealth, they are set to transfer $30 trillion over the next 30 to 40 years to their millennial heirs. While this might not heavily impact the investment community in the year ahead, firms need to begin preparing for the major operational, technological and marketing shifts required to cater to the needs of this vastly different demographic. There is already clear evidence that, when it comes to investing, millennials seek thematic investing and, in particular, socially responsible strategies in keeping with their values and ethics. And, of course, millennials are digital natives — they don't need to be convinced of the value of analytics, data, technology and the cloud.
The pace of change in investment management is accelerating. Complexity is increasing. The application of technology is exploding. Regulation continues to ratchet up. Mounting pressures on performance and fees are unavoidable. But advancements in the fields of big data analytics, machine learning and artificial intelligence only portend good news for the investment industry. These technologies are already being harnessed to produce better products and more engaged investors.
Sebastian Ceria is CEO of Axioma Inc., New York.