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Embracing Change: Humans Plus Machines

January 30, 2020 | Global/Emerging Markets


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Technology, for asset managers and their clients, is less about technology stocks and more about the way disruption affects corporate performance. But what are the implications for active equity asset managers and, by extension, their clients as asset allocators?

The role of the active equity manager has been called into question in recent years as undifferentiated performance, and high fees are compounded by allocators' difficulty in identifying outperforming managers.

But the solutions available to allocators have also changed, thanks to technology. The disaggregation of alpha and beta, cheap passive beta exposure, and the evolution of cheap factor exposures are just a few examples.

A Perfect Era for Passive—But That Will Change

Passive, smart beta, and factor investing take a rules-based approach to varying degrees, and they have the ability to identify and exploit patterns at low to no cost.

But we have been in a perfect era for this. Volatility has been low since the global financial crisis, thanks to abundant capital. And a concentrated set of leaders has dominated the market as a result of winner-take-all economics aided by network effects.

So, while there is a clear role for these strategies, we must remember that passive is, by definition, unable to predict disruptions in economic outcomes and profit pools, and thus any index, however “smart,” is always lagging.

Applications for AI

As for AI, we do see some applications—for example, to help exploit near-term market inefficiencies. Specifically, AI may remove investment manager biases, so implementation and execution improves. But for the foreseeable future, this appears to be effective only over the shorter investment horizons.

I also don't see AI replacing humans. At William Blair, we use machine learning to test and modify the factor models that inform our discretionary process. For now, at least, AI cannot do a better job than humans when it comes to predicting big changes, such as future consumption habits and innovations.

Humans are better at strategy, while machines are better at tactics.

If the next era differs from the past era (due to de-globalization, deconsolidation, and the break-up of big tech, for example), those changes will be better understood by humans than machines. Humans are better at strategy, while machines are better at tactics.

Consider Japan's $1.34 trillion government pension fund, GPIF, which used AI not to predict manager performance but to monitor fund behavior. In other words, does a particular fund behave and react to the market or economy as predicted? Does the manager really do what it says it will do? That's tactical, not strategic.

Profit Pools Shift

As investors in quality growth companies, we are very interested in how technology has changed the nature of competitive advantages, created and destroyed new business models, transformed competition, and changed costs, capabilities, and convenience.

The 20-year history of the retail industry is a good example. In consumer retail, technology has changed how products are created, marketed, and sold. From fast fashion to the customer's information advantage, the entire equation has changed.

It's not a surprise that retail industry profits have grown slightly more than the overall market over the past 20 years, by 6.7% versus 6.5% (represented by the Russell 3000 Index narrowed down to the retail industry).

But the shifts within that growth are surprising. Internet sales now comprise 28% of total retail industry profits, up from nothing 20 years ago (a compound annual growth rate of more than 24% since 1999). Meanwhile, general merchandise and department stores have gone from 55% of total retail 20 years ago to 11% today.

IBM Watson can beat humans at the ancient and intricate game of Go, but could a machine have predicted Amazon's ever-expanding total addressable market (TAM) better than humans could? Doubtful. This is the reality of the nature of the innovation and disruption cycle. It takes creativity, insight, and imagination to identify it.

 A Diversified Approach

What are the takeaways? How can we as asset managers do better? How can our clients do better?

The answer is not to change who we are. One financial behemoth has said it is not an investment bank, but a technology company in the financial services industry. I take issue with that. We don't have to pretend to be technology companies in order to survive in our industry, or any industry.

My framework for adapting to change is to consider the internal forces necessary, the external solutions available, and approaches that combine these elements.

We do, however, have to assess our organization's culture and mindset toward technology. Sometimes in the asset management business, we consider change a dirty word. But evolution is imperative, and a proactive approach to understanding and utilizing technology is better than a reactive one. Success really is about change, and innovation more broadly.

The good news is that many trends—including reduced costs due to digitization, for example—are making things more accessible. But acquiring the capabilities and talent will be challenging, and will take time (not to mention discomfort) to adjust. We are all feeling that already.

Internal Mindset and Culture Key

My framework for adapting to change is to consider the external solutions available, the internal forces necessary, and approaches that combine these elements.

There are many external solutions that provide businesses with the capabilities of bigger organization without the infrastructure and costs, including cloud computing and partnerships with start-up accelerator programs.

But most important may be business leaders taking responsibility. At William Blair, I chair our technology working group, and two years ago we created the role of technology leader within our business unit.

One of our goals is to create a borderless technology environment, bringing technology from the back office into the front office and blurring the boundaries of technology and investment skills.

And, our proprietary Summit research platform codifies our investment process. Specifically, it enables our portfolio managers and analysts to efficiently collaborate to identify high-conviction investment ideas in the pursuit of better client outcomes.

To reiterate, I also don't see technology replacing humans. Humans will continue to have a role, which is why we believe so deeply in the role of active management.

The Power of Technological Change
Part 1: Bullish on Tech—Especially Outside the Tech Sector

Ken McAtamney, partner, is a portfolio manager on William Blair's Global Equity team.