Not Even AI Can Beat the Market These Days

From the earliest days of artificial intelligence (AI) and machine learning (ML) in the 1950s, practitioners have spoken of using it for investment fund management. After all, humans are notoriously bad at investing, as only a minority of money managers beat random security selections, and most who do are probably just lucky. Even successful managers are only able access a tiny fraction of all information relevant to security selection and must guard against a suite of behavioral biases that sabotage strategies. But a tireless machine able to digest all information and immune to human biases should be clearly superior.

So far, that promise has not been realized. The only major fund run by AI – AI Powered Equity ETF - has underperformed and attracted low investor interest. Since opening in October 2017 the fund has returned just under half as much as the Vanguard S&P 500 ETF, or 35.3% versus 70.8%, with slightly more volatility: 24.2% versus 21.5%. The AI ETF – ticker AIEQ - has a beta of 1 to the S&P 500 Index after fees, with an alpha of negative 3.82%, which means it has lost 3.82% to the S&P 500 each year on average over the last five years. However, that alpha is not statistically significant, meaning it’s plausible that AIEQ has a superior long-run expected risk-adjusted return but just had an unlucky five-year run.

Another prominent AI product is HSBC Holdings Plc’s AI Powered US Equity Index, or AIPEX. Since inception in August 2019, the index has returned only 2.3%, compared with 44.8% for the Vanguard 500 Index. However, AIPEX has a 6% annualized volatility target, about one-quarter of the S&P 500’s 24.3% over the same period. AIPEX has hit its volatility target almost exactly, 6.1%, and it has a beta of 0.19 to the S&P 500 and an alpha of negative 1.8% (and like AIEQ, that negative alpha is not statistically significant). AIPEX includes a 50-basis-point index fee and holds most of its hypothetical capital in cash. Adjusting for those two things, AIPEX’s pure stock selection — the measure of the success of its AI - -has lost 6.8% per year to the S&P 500 over the last three plus years.

Nevertheless, AI is making strong inroads in investment management. The main area is processing “unstructured data” like news stories and text reporting. There’s no doubt that AI trumps humans at this; it can read everything, in all languages, and distill the useful information. It can process pictures and anything else that can be converted to bytes in a computer file. The amount of such data is growing rapidly, and the sophistication of algorithms to process them, so AI will continue to advance in this task.