The Hedge Fund King and a Technological Arms Race

(Bloomberg Opinion) -- Luke Ellis, the CEO of Man Group Plc, exemplifies the challenge facing the whole of the investment management industry: how does the world's largest publicly traded hedge fund win a technological arms race that's roiling the entire business?

Hedge-fund managers are in agreement that alpha is becoming more elusive as both the data and the techniques used to sort through the numbers become more widely available. The business is undergoing a Darwinian thinning of the herd, with a decline in both the number of new firms opening and the number of shops closing their doors.

The surge in money flowing to passive investment strategies suggests investors have a newfound awareness that they've been paying elevated fees to funds that are closet index-trackers. A proper bifurcation between cheaper products that only pledge to deliver beta and more expensive offerings that maintain they can generate true alpha should kill off the pretenders. And that seems to be happening.

The Hedge Fund King and a Technological Arms Race

But judging by the way asset management stocks have moved this year, investors are highly skeptical of the industry's ability to prosper against a backdrop of lower fees, increased regulation, rising market volatility and the expense of funding the aforementioned arms race. The sector has suffered disproportionately this year as the global stock market has dropped. Man is no exception; its shares have lost almost about 40 percent of their value.

The Hedge Fund King and a Technological Arms Race

But of the 15 analysts that follow Man Group, none recommend selling the stock. Seven rate it worth buying and the remaining eight advise investors to hold. As the chart above suggests, though, the shares will have to recoup all of this year's losses to reach the consensus 12-month price.

To keep the money rolling in, Man needs to deliver returns for its customers. It lost $1.8 billion in the first quarter of this year, though its performance rallied in the second quarter to trim first-half investment losses to $1.7 billion.

And a key element of its strategy is to harness advances in machine learning, artificial intelligence and other computing technologies to gain an edge in both trading and execution.

Earlier this year Ellis, a 55-year-old with a degree in mathematics and economics from Bristol University, told clients that the outcome of a programming competition with some of his senior managers would be “embarrassing” for him. In a presentation, he outlined his ambitions for the firm's engagement with technology:

We want to use that in our alpha generation, in our trade execution, in our portfolio construction, in the way we interact with clients, in the way our back-office processes work, in the way our risk management processes work. Efficiency in asset management is incredibly important. It gets harder every day to find alpha, that's because the world becomes more transparent every day. But what really, really matters is the efficiency of turning your alpha into returns for the client.

This isn't so much about building smarter robots and writing better algorithms to free the computers to choose what investments to make, although there's an element of that. The key requirement is to employ technology to improve the performance of the firm's humans in delivering better returns for clients.

Suppose an investment manager decides Deutsche Bank AG's 50 percent decline this year makes the stock a screaming buy. That investment would add to the firm's exposure to the finance industry, to the country, and to European regional risk. So maintaining balance across the portfolio's strategy might require corresponding sales of some holdings – and while computers are perfectly suited to calculating and flagging the need for such cross-portfolio tweaks, humans are still better at deciding which stocks to offload – at least for now.

Given the relentless downward pressure on fees, amplifying the returns to investors by shaving costs wherever possible is another imperative. Here, technology can help with tasks such as generating customized client reports, particularly for a firm like Man, which says more than half of the money it manages comes from customers with investments in four or more of its products.

Man's sales force has certainly been doing its job. On the all-important metric of assets under management, the firm enjoyed record net inflows in the first half of the year, and eked out a further gain in the third quarter.

The Hedge Fund King and a Technological Arms Race

The total Man oversees has doubled in the past five years. To repeat that growth rate in the next half-decade, Ellis needs to oversee a harmonious integration of people and technology. If he gets it wrong, a whole industry will be watching.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mark Gilbert is a Bloomberg Opinion columnist covering asset management. He previously was the London bureau chief for Bloomberg News. He is also the author of "Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable."

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