Since I agreed to write this article a few weeks ago, the financial world has already changed profoundly. As I write, the venerable name of Lehman Brothers has followed that of Bear Stearns into the history books, the ‘good’ parts having been snapped up by Barclays in the US, and by Nomura in Europe; Merrill Lynch has been absorbed into Bank of America; Wells Fargo has acquired Wachovia; JP Morgan has rescued Washington Mutual; Morgan Stanley and Goldman Sachs have converted themselves into commercial banks; AIG has been nationalised, as have Bradford & Bingley and, at least partially, Fortis, the dominant player in Benelux, where Dexia is also being bailed out. The list goes on, growing daily. The major market indices are down around 25% over the last 12 months. Moreover, the US Government has so far failed to push through its US$700 billion rescue plan.
The future of the hedge fund industry is also plagued by uncertainty. While they have generally outperformed the underlying markets, more than 90% of funds are reported to be below their high-water-mark levels, so are earning zero performance fees. Shorting of stocks has been restricted in many of the major markets and there is talk that 25% or more of hedge funds will fail or shut down. Performance enhancement through leverage has become much harder to achieve due to lack of credit. Funds are concerned about the credit risk of their prime brokers, many having been burned by the Lehman collapse. The happy symbiosis between funds and their prime brokers that has seen both prosper for the last 10 years has ended, at least temporarily. Many funds await the September redemption figures with trepidation. Global AUM in hedge funds is likely to see a sharp reverse as investors seek safe havens. US Treasury yields even went negative at one point as panicked investors sought security above all else.
Perhaps by the time you read this, the ‘super-crisis’ will have passed, the doom-mongers will have retreated and the recovery will be underway.
Either way, my goal was to try and lift my eyes to the horizon beyond the immediate gloom of bail-outs, write-downs and job losses to consider how technology may shape the way we invest in 5-10 years time. I have based my predictions on technologies that broadly exist today, but are not yet mainstream, combined with some speculation as to how things may play out. The views expressed are my own.
The five key strands that I believe will shape the investment landscape of the future are:
• Massive, accessible computing power, combined with vast arrays of data, such as tick-by-tick price histories, previously only available to specialists.
• Convergence of liquidity into a handful of global super-exchanges that allow 24-hour investment in virtually any asset.
• Instantaneous, real-time settlement of any trade.
• Continuous, mobile access to computing power and data through high-bandwidth connections from super-powerful portable devices.
• Increased use of artificial intelligence to manage the whole investment process, both for individuals, and collective investments.
Each of these is considered in more detail below.
1. Advances in computing power and data availability
Google already has data centres around the world that service the 7 billion search requests they currently receive every month. So do Microsoft, Yahoo and other search providers. Today, anyone can search for anything, anytime, and get an instant answer – for free.
Microsoft, IBM and others now talk about ‘The Cloud’ as the next big thing – an array of powerful devices just waiting on the internet to do your numerical bidding, probably for a fee. The standards and technologies aren’t quite there yet, but they are coming. Industry analysts say they will be mainstream within five years. Combine this with the initiatives such as OpenTick (www.opentick.com) that already provide free or low-cost access to terabytes of historical price data, and you have a recipe for powerful analytics, such as Monte Carlo simulations, that anyone can use to support their investment process, if not for free, then at a much lower cost than hitherto and without the need for massive internal infrastructure.
2. Exchange Convergence and 24-hour trading
A combination of regulatory change (e.g. MiFID) and globalisation (e.g. the NYSE-Euronext merger) has seen rapid evolution of raw execution services, the basic business of uniting willing buyers with willing sellers.
Investors have always been subjected to two competing tensions in their search for ‘best’ execution:
• Concentration of liquidity into one exchange mechanism helps to optimise price formation , but at the risk of monopolistic service charges by the exchange provider. In reality, many investors or their brokers have sought to use technology to re-aggregate multiple execution venues into a single virtual exchange.
• The desire for transparency is countered by fear of adverse price impact in a highly efficient marketplace, fuelling the growth of dark pools alongside the more traditional exchanges. What you gain in anonymity and impact-avoidance, you lose in execution certainty.
Over time, this is likely to see the evolution of a handful of super-exchanges that provide a combination of services: continuous, transparent execution for smaller sizes, and periodic, opaque auctions for large blocks. There may also continue to be some on-line negotiation (request-for-quote) mechanisms for less liquid asset types. The exchanges will act as central counterparty, at least for the continuous execution element. As today, investors are likely to use virtual aggregation to create a single, global mega-exchange that presents all available liquidity.
These super-exchanges will offer 24-hour execution in virtually any asset or derivative, including currencies. Indeed the recent turmoil is likely to fuel a move away from opaque bi-lateral OTC contracts in derivatives such as Credit Default Swaps, to more vanilla products capable of exchange trading, and with centralised counterparty liability. The 24/7 marketplace will create some interesting operational challenges. Even technology can’t overcome the fact that we live in different time-zones, so at what point will a stock go ex-dividend, and how will this be reflected in the real-time order books within the super-exchanges? Will interest still be accrued on a daily basis, when the concept of a ‘day’ starts to lose its meaning? No doubt someone will figure this out.
3. Real-time Settlement
It is not so many years since exchanges operated two-week ‘account periods’. All trades within the period were then settled on a given day shortly after the end of that period. This has generally been replaced with rolling T+n days settlement, with the value of ‘n’ coming down from five to three or less, in efforts to improve efficiency and mitigate settlement risk. We are also, finally, seeing banks adopting as mainstream the technology to send each other payments in real time. In future, title to assets will be fully dematerialised (no more paper certificates) and so there is no reason why movements of cash and assets cannot be instantaneous at the point of execution. You won’t be able to buy assets unless you have already dedicated the cash in advance and settlement costs will in many cases become negligible due to the efficiencies achieved. In the case of shares, your name will be on the register as beneficial owner from the instant the trade is done. It is just a matter of joining up the dots. For margin-traded products such as futures, similar economies of cash movements will also be possible. This means that in many cases, it will be possible to rebalance a portfolio in real time, the only barrier being a trade-off against transaction costs.
4. Mobile Access
Billions are being invested today in LTE – ‘Long Term Evolution’ - or 4G mobile networks. Inevitably there are competing standards, but we can be sure that bandwidth will increase by orders of magnitude, as will the power of the devices we carry around. Think laptop, video-phone and entertainment console in one portable package. Moreover, these devices will have continuous access to the clouds of super-powerful servers and data mentioned above. Individuals running their own money, and managers acting for others, will be able to monitor and adjust their investments at any time: on an aircraft, on the subway, in a taxi. The need to spend time at our desks will be greatly reduced. Maybe the morning rush hour will be a little less crowded.
5. Investment through Artificial Intelligence
The single most significant consequence of all the changes mentioned above will be huge increases in automation of the investment process, not just the bread-and-butter part, but the actual investment decisions. This will go well beyond the current vogue for algorithmic trading. Indeed the trader whose job is to place orders into an exchange will be a very rare beast. Most trading will just be an automatic consequence of applications that act to pursue a high-level investment objective. I believe there will be much less squeamishness about personal information that is vital to financial planning. Individuals will accept that, by combining personal genetic information with statistical, actuarial data, they can tailor their investment programs to the likely needs of themselves and their families.
It might seem frightening or unnatural to ask the question ‘when am I likely to die, based on my genetics, lifestyle and other factors such as location’, but once I get past that, then I can surely make more appropriate investment decisions (and we can be sure that our insurers are asking exactly that question on our behalf). Supposing I were able to feed the following (fictional) details into a clever software application:
• I’m 37.
• Based on my genetic make-up, lifestyle and location, there is a 95% chance that I will die between 83 and 88.
• I earn £80,000 per annum.
• I want to retire at 60, and to have an income of at least £50,000 per annum, inflation adjusted back to today’s money, to cover me to the age of 88. I want to be 80% sure of achieving this objective, and 95% sure to get at least £40,000 per annum.
• I don’t want to invest in tobacco or armaments companies.
• I accept that the targets are net of fees, for which I am willing to pay up to 1.5% of my invested capital, depending on achievement of targets.
The smart application should be able to figure out how much I need to invest to maintain this objective, by sending off requests to the super-servers with their access to data and investment models. I can then choose whether to accept that figure. The application will then select a global portfolio across multiple asset classes, that balances risk and returns appropriately. It will continuously monitor my adherence to the objectives 24/7, automatically interpreting news and research information, as well as raw numbers. Necessary trades will be instantly executed and settled, finding the best execution without human intervention. Currency exposure will be automatically hedged. I will be able to monitor my plan anywhere in the world on my super-mobile and adjust my objectives, or feed in new instructions whenever I like. No more opaque annual statements from a remote pension provider. The applications will have to be so smart that they do not succumb to the kind of lock-step herd-like behaviour that we saw from many of the quant funds in 2007 – similar models, similar response to events. There are already claimed to be execution algos that detect and react to other algos. This will simply be the next level.
The future for hedge funds
Where will this leave the Hedge Funds? And where will it leave the sell side as providers of execution services? How far will the disintermediation go?
Firstly, the need to manage wealth and plan for our futures will not go away, indeed the population and wealth of the planet will grow. Investment will simply become a much more automated process for the mainstream.
Secondly, many hedge fund strategies will continue to present opportunities. Long/short equity (to the extent allowed by regulators) will still be possible, backed by smarter algorithms designed to outperform those adopted by the traditional managers; statistical arbitrage may even be easier with fewer exchanges to access; event-driven, merger arbitrage and distressed debt will be largely unaffected; global macro managers can still make bets on the direction of interest rates and currencies.
Thirdly, there will be asset classes that continue to defy exchange listing, or at least fully-automated trading, and that will provide opportunities for hedge funds as providers to ‘qualified investors’ who seek exceptional returns on their risk capital. These could be anything from fine wines, to racehorses, to art; of course there will still be many private equity opportunities; and there will be room for OTC derivatives that cannot be standardised and listed, once the current clamour for regulation and transparency runs its course.
Will access to the super-exchanges be via member-brokers, or will investors simply sign up directly, agreeing to abide by rules regarding orderly markets? Once the exchanges have coalesced from the current 200+ into a handful of facilities, then it is more realistic for managers to join up directly. The sell-side will have to find other revenue sources to replace the lost commissions.
In summary, we may all end up working harder for longer, but at least technology will make our lives more predictable, mostly in a good way, and alternative managers will undoubtedly show their usual creativity in exploiting the opportunities offered by the changing landscape.
The future of the hedge fund industry is also plagued by uncertainty. While they have generally outperformed the underlying markets, more than 90% of funds are reported to be below their high-water-mark levels, so are earning zero performance fees. Shorting of stocks has been restricted in many of the major markets and there is talk that 25% or more of hedge funds will fail or shut down. Performance enhancement through leverage has become much harder to achieve due to lack of credit. Funds are concerned about the credit risk of their prime brokers, many having been burned by the Lehman collapse. The happy symbiosis between funds and their prime brokers that has seen both prosper for the last 10 years has ended, at least temporarily. Many funds await the September redemption figures with trepidation. Global AUM in hedge funds is likely to see a sharp reverse as investors seek safe havens. US Treasury yields even went negative at one point as panicked investors sought security above all else.
Perhaps by the time you read this, the ‘super-crisis’ will have passed, the doom-mongers will have retreated and the recovery will be underway.
Either way, my goal was to try and lift my eyes to the horizon beyond the immediate gloom of bail-outs, write-downs and job losses to consider how technology may shape the way we invest in 5-10 years time. I have based my predictions on technologies that broadly exist today, but are not yet mainstream, combined with some speculation as to how things may play out. The views expressed are my own.
The five key strands that I believe will shape the investment landscape of the future are:
• Massive, accessible computing power, combined with vast arrays of data, such as tick-by-tick price histories, previously only available to specialists.
• Convergence of liquidity into a handful of global super-exchanges that allow 24-hour investment in virtually any asset.
• Instantaneous, real-time settlement of any trade.
• Continuous, mobile access to computing power and data through high-bandwidth connections from super-powerful portable devices.
• Increased use of artificial intelligence to manage the whole investment process, both for individuals, and collective investments.
Each of these is considered in more detail below.
1. Advances in computing power and data availability
Google already has data centres around the world that service the 7 billion search requests they currently receive every month. So do Microsoft, Yahoo and other search providers. Today, anyone can search for anything, anytime, and get an instant answer – for free.
Microsoft, IBM and others now talk about ‘The Cloud’ as the next big thing – an array of powerful devices just waiting on the internet to do your numerical bidding, probably for a fee. The standards and technologies aren’t quite there yet, but they are coming. Industry analysts say they will be mainstream within five years. Combine this with the initiatives such as OpenTick (www.opentick.com) that already provide free or low-cost access to terabytes of historical price data, and you have a recipe for powerful analytics, such as Monte Carlo simulations, that anyone can use to support their investment process, if not for free, then at a much lower cost than hitherto and without the need for massive internal infrastructure.
2. Exchange Convergence and 24-hour trading
A combination of regulatory change (e.g. MiFID) and globalisation (e.g. the NYSE-Euronext merger) has seen rapid evolution of raw execution services, the basic business of uniting willing buyers with willing sellers.
Investors have always been subjected to two competing tensions in their search for ‘best’ execution:
• Concentration of liquidity into one exchange mechanism helps to optimise price formation , but at the risk of monopolistic service charges by the exchange provider. In reality, many investors or their brokers have sought to use technology to re-aggregate multiple execution venues into a single virtual exchange.
• The desire for transparency is countered by fear of adverse price impact in a highly efficient marketplace, fuelling the growth of dark pools alongside the more traditional exchanges. What you gain in anonymity and impact-avoidance, you lose in execution certainty.
Over time, this is likely to see the evolution of a handful of super-exchanges that provide a combination of services: continuous, transparent execution for smaller sizes, and periodic, opaque auctions for large blocks. There may also continue to be some on-line negotiation (request-for-quote) mechanisms for less liquid asset types. The exchanges will act as central counterparty, at least for the continuous execution element. As today, investors are likely to use virtual aggregation to create a single, global mega-exchange that presents all available liquidity.
These super-exchanges will offer 24-hour execution in virtually any asset or derivative, including currencies. Indeed the recent turmoil is likely to fuel a move away from opaque bi-lateral OTC contracts in derivatives such as Credit Default Swaps, to more vanilla products capable of exchange trading, and with centralised counterparty liability. The 24/7 marketplace will create some interesting operational challenges. Even technology can’t overcome the fact that we live in different time-zones, so at what point will a stock go ex-dividend, and how will this be reflected in the real-time order books within the super-exchanges? Will interest still be accrued on a daily basis, when the concept of a ‘day’ starts to lose its meaning? No doubt someone will figure this out.
3. Real-time Settlement
It is not so many years since exchanges operated two-week ‘account periods’. All trades within the period were then settled on a given day shortly after the end of that period. This has generally been replaced with rolling T+n days settlement, with the value of ‘n’ coming down from five to three or less, in efforts to improve efficiency and mitigate settlement risk. We are also, finally, seeing banks adopting as mainstream the technology to send each other payments in real time. In future, title to assets will be fully dematerialised (no more paper certificates) and so there is no reason why movements of cash and assets cannot be instantaneous at the point of execution. You won’t be able to buy assets unless you have already dedicated the cash in advance and settlement costs will in many cases become negligible due to the efficiencies achieved. In the case of shares, your name will be on the register as beneficial owner from the instant the trade is done. It is just a matter of joining up the dots. For margin-traded products such as futures, similar economies of cash movements will also be possible. This means that in many cases, it will be possible to rebalance a portfolio in real time, the only barrier being a trade-off against transaction costs.
4. Mobile Access
Billions are being invested today in LTE – ‘Long Term Evolution’ - or 4G mobile networks. Inevitably there are competing standards, but we can be sure that bandwidth will increase by orders of magnitude, as will the power of the devices we carry around. Think laptop, video-phone and entertainment console in one portable package. Moreover, these devices will have continuous access to the clouds of super-powerful servers and data mentioned above. Individuals running their own money, and managers acting for others, will be able to monitor and adjust their investments at any time: on an aircraft, on the subway, in a taxi. The need to spend time at our desks will be greatly reduced. Maybe the morning rush hour will be a little less crowded.
5. Investment through Artificial Intelligence
The single most significant consequence of all the changes mentioned above will be huge increases in automation of the investment process, not just the bread-and-butter part, but the actual investment decisions. This will go well beyond the current vogue for algorithmic trading. Indeed the trader whose job is to place orders into an exchange will be a very rare beast. Most trading will just be an automatic consequence of applications that act to pursue a high-level investment objective. I believe there will be much less squeamishness about personal information that is vital to financial planning. Individuals will accept that, by combining personal genetic information with statistical, actuarial data, they can tailor their investment programs to the likely needs of themselves and their families.
It might seem frightening or unnatural to ask the question ‘when am I likely to die, based on my genetics, lifestyle and other factors such as location’, but once I get past that, then I can surely make more appropriate investment decisions (and we can be sure that our insurers are asking exactly that question on our behalf). Supposing I were able to feed the following (fictional) details into a clever software application:
• I’m 37.
• Based on my genetic make-up, lifestyle and location, there is a 95% chance that I will die between 83 and 88.
• I earn £80,000 per annum.
• I want to retire at 60, and to have an income of at least £50,000 per annum, inflation adjusted back to today’s money, to cover me to the age of 88. I want to be 80% sure of achieving this objective, and 95% sure to get at least £40,000 per annum.
• I don’t want to invest in tobacco or armaments companies.
• I accept that the targets are net of fees, for which I am willing to pay up to 1.5% of my invested capital, depending on achievement of targets.
The smart application should be able to figure out how much I need to invest to maintain this objective, by sending off requests to the super-servers with their access to data and investment models. I can then choose whether to accept that figure. The application will then select a global portfolio across multiple asset classes, that balances risk and returns appropriately. It will continuously monitor my adherence to the objectives 24/7, automatically interpreting news and research information, as well as raw numbers. Necessary trades will be instantly executed and settled, finding the best execution without human intervention. Currency exposure will be automatically hedged. I will be able to monitor my plan anywhere in the world on my super-mobile and adjust my objectives, or feed in new instructions whenever I like. No more opaque annual statements from a remote pension provider. The applications will have to be so smart that they do not succumb to the kind of lock-step herd-like behaviour that we saw from many of the quant funds in 2007 – similar models, similar response to events. There are already claimed to be execution algos that detect and react to other algos. This will simply be the next level.
The future for hedge funds
Where will this leave the Hedge Funds? And where will it leave the sell side as providers of execution services? How far will the disintermediation go?
Firstly, the need to manage wealth and plan for our futures will not go away, indeed the population and wealth of the planet will grow. Investment will simply become a much more automated process for the mainstream.
Secondly, many hedge fund strategies will continue to present opportunities. Long/short equity (to the extent allowed by regulators) will still be possible, backed by smarter algorithms designed to outperform those adopted by the traditional managers; statistical arbitrage may even be easier with fewer exchanges to access; event-driven, merger arbitrage and distressed debt will be largely unaffected; global macro managers can still make bets on the direction of interest rates and currencies.
Thirdly, there will be asset classes that continue to defy exchange listing, or at least fully-automated trading, and that will provide opportunities for hedge funds as providers to ‘qualified investors’ who seek exceptional returns on their risk capital. These could be anything from fine wines, to racehorses, to art; of course there will still be many private equity opportunities; and there will be room for OTC derivatives that cannot be standardised and listed, once the current clamour for regulation and transparency runs its course.
Will access to the super-exchanges be via member-brokers, or will investors simply sign up directly, agreeing to abide by rules regarding orderly markets? Once the exchanges have coalesced from the current 200+ into a handful of facilities, then it is more realistic for managers to join up directly. The sell-side will have to find other revenue sources to replace the lost commissions.
In summary, we may all end up working harder for longer, but at least technology will make our lives more predictable, mostly in a good way, and alternative managers will undoubtedly show their usual creativity in exploiting the opportunities offered by the changing landscape.
