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Oct. 19, 2012
Harnessing high-tech power
Technological innovations can help improve portfolio returns.
ARI SHIFF
Many investors today have successfully harnessed new technologies to manage their portfolios. Ironically, however, many of those same investors employ asset managers who have yet to adopt some of the innovative techniques and technologies that have transformed professional investment theory and practice over the last two decades. The same innovation that has shrunk a room-sized IBM mainframe to the size of the smartphone in your hand has also transformed the leading edge of the investment industry. Technology now exists to attempt both to mitigate risk and pursue higher profits in the average investor’s portfolio by introducing hedged strategies that may offer uncorrelated sources of return.
An investor of 50 years experience recently recounted her growing frustration with the past decade of negative returns in her large equity and bond portfolio. Like many of us, she is searching for both higher yield and greater safety to provide her with annual income and conservative asset growth and, like many of us, she has given up hope of being able to meet those needs with the traditional mix of equity managers that worked for her in the past. Yet, in searching for yield, she had discounted the potential superior returns of alternative investments like hedge funds because it was a new structure that was unfamiliar to her.
She and her late husband made their fortune as pioneers in real estate and equity investing before the popularization of long-short investing as a safer alternative to long-only investing. However, once she understood that hedge funds employ newer technologies to extract comparative advantage and profit, she realized that it was an evolutionary improvement in investing technology in exactly the same way that she and her husband had skillfully applied what were the technological innovations of their time to a time-honored trade.
Smart traders have existed for millennia. The Bible has plenty of examples of canny investors who had a keen eye for quality and understood the advantage of moving goods from a market of plenty to a market of scarcity (a trade that now goes by the fancy term “arbitrage”). To these ancient skills, modern traders have added an arsenal of advance technological tools to help extract profit more efficiently from opportunities that would have previously been too narrow or too complex to exploit.
One of the most powerful innovations has been the astonishing rise of computing speed and capacity. The ability to crunch huge amounts of data quickly created new opportunities to trade. An early example was back in the late 1980s, when it became possible to make healthy profits simply by arbitraging small discrepancies between stock market index prices and their component stocks. Though the difference in price was fleeting and miniscule, computers were able to exploit the momentary dislocation and execute thousands of trades, collecting millions of pennies. And those pennies added up.
Variations of this computer-assisted arbitrage are still being used, but with tweaks to adapt them to today’s markets. In the last few months, some hedge-fund managers have extracted robust profits from the economic mayhem in Europe by trading sovereign bonds. Combining specialized databases and super-fast computers with good old-fashioned intelligence, some managers are able to spot mis-pricings when markets over-react to the latest news, and then use their trading skill to lock in the profit.
As the financial industry has harnessed the power of computers to create increasingly sophisticated financial products, savvy managers have employed computers and complex programs to improve the precision of their trades, allowing them to focus intently on the most profitable opportunities while attempting to eliminate taking on risks for which they would not be adequately compensated. The meltdown of the U.S. residential lending market in 2008 unleashed a torrent of financial assets, sliced and diced pieces of various mortgages, each with its own risk/reward characteristics and each trading according to macroeconomic factors that can change daily. Bright managers, trading with a knowledge advantage, were able to buy exactly the exposure they wanted, such as to falling interest rates, while hedging away the risks they wished to avoid.
For investment managers, technological innovation has led to powerful new tools for controlling the risks inherent in any opportunity. Even a very good trader can be whipsawed by volatility and get caught on the wrong side of a sudden swing in pricing. The “Great Collapse” of 2008 was the most recent and dramatic example of this, but the frequency of volatility spikes and large-scale surprises has been building over the last decade.
To combat this increase in volatility, the most sophisticated investment managers now employ risk managers who sit side by side with the risk-taking traders and use complex programs to rebalance portfolios, hedge away unwanted exposures and avoid conflicting investments in an attempt to avoid unprofitable outcomes under many different possible scenarios.
For Canadian investors, all of these innovations have created the potential for greater control through portfolio diversity. Individual investors would do well to question their managers on real-time risk management and hedged strategies. While Canadians have historically done well from the country’s exposure to the commodity and natural resource sectors, the global dynamics of trade are creating strong headwinds for Canadian equities, preferred shares and bonds. While those traditional long-only sources of return still deserve a prime place in investors’ portfolios, alternate potentially uncorrelated sources of return using more innovative long-short strategies are also needed to preserve wealth and produce returns during periods of contraction such as the one we are now experiencing.
Alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. Past performance is not necessarily indicative of future results. Consult with your professional advisor before making any investment.
Ari Shiff is the founder and head of research at Inflection Management Inc., and the manager of the Inflection Strategic Opportunities Fund. Shiff has more than 15 years experience in hedge funds and can be reached at [email protected] or at 604-730-9147.
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