Winner Takes All ?
In 1996 Garry Kasparov, probably the greatest chess player of all time, was challenged by Deep Blue, an IBM supercomputer which could be considered to be one of the earliest examples of artificial intelligence (although many people would argue that it was just a sophisticated algorithm). The human won although not without some problems. However, a year later a more sophisticated Deep Blue won the rematch and it’s not an exaggeration to say that the world hasn’t been the same since.
IBM further improved Deep Blue to create Watson, capable of processing hundreds of algorithms simultaneously and beating all comers at Jeopardy. Perhaps more interestingly, in 2016 Google’s Deep Mind beat 18-time world champion Lee Sedol at Go, a more mathematically complicated game than chess, using reinforcement learning and a neural network that can be regarded as similar to that proposed by Alan Turing several decades earlier.
This battle between man and machine has obvious lessons for the fund management industry. Probably the best-known fund manager of recent times is Warren Buffet. Berkshire Hathaway has enjoyed annual growth of 19% since 1965 which is roughly twice that of the S&P 500 Index over the same period even if this difference has been narrowing in recent years. His company has now become one of the largest in the US.
Jim Simons, unlike Warren Buffet, is not a household name although he is obviously well known to people in the fund industry. He established Renaissance Technologies in 1982 and his flagship Medallion Fund six years later. This fund had a staggering 72% annual return from 1994 to 2014 and almost doubled in the year when Lehman Brothers collapsed. At its peak, the company could impose a management fee of well over 40% and still be obliged to turn away investors.
Whilst Warren Buffet is an amazingly astute “value” investor, poring over balance sheets for months before making an investment, Jim Simons is a world leading mathematician and used to work as a cryptologist for the CIA. His company employs mathematicians, physicists, statisticians but no one with a financial background. It’s interesting to note that Renaissance doesn’t employ economists either and the history of Long-Term Capital Management would seem to prove them right.
Simons’ approach, certainly with the Medallion Fund, is considerably more successful than Buffet’s and would seem to suggest that a sophisticated algorithmic approach is more successful than one based on value. The poor performance of most hedge funds in recent years may seem to contradict this but I would argue that a hedge fund is only as good as its algorithm just as a value fund manager is only as good as his financial analyses. Poor hedge fund managers, like broken watches, will be right occasionally.
The success of Renaissance, in my opinion, is a testament to the immense complexity of their big data analytics and a precursor of what lies ahead as artificial intelligence becomes ever more complex. The neuroscientist Sam Harris believes that “Free will is an illusion. Our wills are simply not of our own making. Thoughts and intentions emerge from background causes of which we are unaware and over which we exert no conscious control.” This would seem to suggest that artificial intelligence, once it reaches the necessary level of sophistication, can predict the behaviour of all human beings and, by extension, that of the financial markets.
It’s clear that artificial intelligence is not just a trend, a phase that will disappear, but a phenomenon that will hugely impact financial services and almost all other aspects of our lives. Indeed, this impact may be so fundamental that certain highly respected scientists and scholars believe that it could threaten our very existence. Stephen Schwarzman, the founder of Blackstone and no mean investor himself, recently donated £150m to Oxford University to fund research in humanities including an Institute for Ethics in Artificial Intelligence. The funds are not therefore designed to fund studies in artificial intelligence but rather to make sure that artificial intelligence is used in an ethical way to serve and not destroy humanity. This is a huge difference and an admission of the potential risks inherent in the new technology. Indeed, Stephen Hawking warned that “the development of full artificial intelligence could spell the end of the human race.”
To return to the fund industry, we could imagine that the company which creates the most efficient artificial intelligence will dominate the industry and gain huge market share. The winner, in other words, will take all just as Google has become the dominant force in Internet browsing and Amazon in Internet shopping. However, the history of Renaissance does perhaps contain some hope for the future. Firstly, the group’s other funds aren’t as successful as the Medallion Fund and, secondly, the very success of the latter led the company to close the fund after only a few years to limit the assets to “only” about $9-10bn. Regular annual returns of over 70% are difficult under any circumstances but probably impossible for investments in excess of $10bn. Furthermore, technical measures have been implemented by stock exchanges to avoid excess volatility and prevent “winner take all” positions from being implemented.
To conclude, the lessons of Renaissance would seem to suggest that artificial intelligence will make life increasingly difficult for the fund industry in the future but that there will still be a certain place for human judgement. This human judgement will, however, have to be exceedingly compelling to convince investors that they will obtain better returns with man than with machine.