Why algorithmic trading will eventually replace fund managers

The traditional fund manager who uses his or her “expertise” to select stocks for their clients will gradually become an endangered species (and they know it). This is why you have been hearing a lot of negativity from these people about high frequency/algorithmic trading in recent times. These people know that their own returns are materially inferior to that of many high frequency/algorithmic traders.

As I’ve said previously here, most fund managers (and very especially Australian fund managers) have no discernable stock picking skills. Sure, you will have those who can point to index beating records over relatively short periods of time, but show me any fund manager in Australia who has returned a compound 15-20%+ over 20 or more years – they simply don’t exist. Most of them can’t even match a low cost index fund over time.

Many of these people have reached a station in life which is out of all proportion to their actual abilities. They have been able to so this by taking passive fees on assets under management which amount to billions of dollars across the industry.

How do they attract funds? Here’s how:

1. Firstly make sure you have a few years of good performance under your belt. This will have been obtained by simply getting lucky, playing popular (but temporary) trends, or with the assistance of a raging bull market (or all three);
2. If you can, appear in the media as an “expert” – the media classes anyone who is employed in the investment industry and who is breathing as an “expert”;
3. It always helps to have some charisma and to come across confidently;
4. Market your returns to investors who are too naïve to see through you and too lazy to care about the management of their own money;

 There you have it. Now you can sit back and charge 1-2% on assets for lousy performance. This can amount to millions of dollars and if you fail later on, don’t worry, you will get to keep all of your ill-gotten gains which were made when times were good.

Remember the full service stock brokers and also the old market makers? These guys use to rip us off – they literally stole our money for doing very little. Most of those guys are now out of business due to the internet and alternative market places and every day I’m thankful for that.

(Incidentally, I know many high frequency traders are involved in market making too, but their spreads are much lower than the old time market makers. The modern high frequency market makers simply cannot capture similar spreads to what the old market makers use to.)

The fund manager belongs in the same category as the old time stock brokers and market makers. Nearly all of them over-charge their clients. If you do not take responsibility for your own investments (including superannuation), you can be sure that someone is enjoying a very pleasant life style at your expense.

But why is algorithmic trading superior?

1. Algorithmic strategies can be accurately tested on vast amounts of data (often in seconds or minutes);
2. Algorithmic strategies can be executed by computers, removing human emotion from trading decisions;
3. Algorithmic strategies are consistent in what they do (unlike many humans);
4. Algorithms can detect patterns that are imperceptible to humans;
5. Algorithms can scan vast amounts of data, much more than a human ever could;
6. Algorithms can adapt to different environments, something many humans cannot do;
7. Properly conceived and successfully tested algorithms have predictive ability, something the vast majority of humans do not;
8. Advances in computing power are making algorithmic strategies cheaper and cheaper to implement as time goes by;
9. Because most algorithmic strategies are short-term, they are not as exposed to general market risk as buy and hold strategies, (e.g. regulatory risk is an all too common factor in Australia these days);
10. For all of the above reasons, algorithms have now advanced to the stage where they can trade stocks better than many humans.

This is why, over time, the traditional fund manager will go the way of the Dodo. As will the analysts at the investment banks and the economists (if you want to be rich, don’t listen to these people – they have mortgages). Algorithms can do all of their jobs much better than they can and in years to come they will.

The lazy, over-compensated fund managers will make a lot of noise and attempt to frighten people to maintain the status quo, but it will ultimately be futile.