Meet the new stock pickers. They will remind you of the old stock pickers.
One thing to watch for next year is AI-driven investment products. There’s a lot of buzz around Wall Street about artificial intelligence taking over from real-life fund managers, presumably because AI will be better at picking stocks.
It can’t do worse. Twice a year, S&P Global Inc.’s Spiva scorecard shows that most active managers unfailingly lose to a broad stock market index over most time periods. S&P’s report doesn’t extend to hedge funds, but they haven’t fared any better.
Enter AI with hopes of doing what mortal managers can’t. Don’t hold your breath. For starters, in aggregate, stock pickers end up with the market return minus fees, as the late Vanguard Group Inc. founder John Bogle often reminded investors. That applies to humans as well as bots. So, as a group, the bots are destined to lose.
Sure, some will beat the market, but many won’t win by a big enough margin to overcome their fees. The experience of real-life stock pickers is instructive. I counted more than 7,000 actively managed stock mutual funds for which Morningstar calculated risk-adjusted returns relative to the market over the past 10 years. Roughly 45% of them won before fees, but only 27% won after accounting for cost.
Another challenge for AI is competition from other bots. The truth is that human stock pickers are already obsolete. There are numerous low-cost exchange-traded funds that replicate traditional stock-picking strategies, such as value, quality and momentum, often following a rules-based, quantitative approach mostly run by computers. Like human managers, they don’t always beat the market, but the low-cost ones have a much better shot.
So, to be relevant, AI will have to go beyond traditional stock picking — it will have to invent new ways to beat the market. And maybe it will, but that won’t necessarily help investors. To profit from AI, investors will have to play the same low-odds game they’ve always played with fund managers — namely, pick the winners in advance.
That’s easier said than done. It’s nearly impossible to predict which stock picker will beat the market. New managers don’t have a track record to go by, and most of the ones with a winning record don’t continue to win. Even if AI proves to be a more persistent winner, investors will quickly pile into the best funds and constrain their capacity, forcing them to turn away new investors. The only alternative is to guess which AI will be the best stock picker – and for most investors it can only be a guess given AI’s opacity. That’s no way to invest.
AI may not be better for investors, but it’s a godsend for Wall Street. Profits of big banks and fund companies have been squeezed by zero commissions, low-cost index funds and robo-advisers. In response, many have pinned investors’ hopes of outsize returns on high-priced “alternatives,” mostly hedge funds, private equity and venture capital. But these alternatives are now weighed down by trillions of dollars chasing too few investment opportunities, and performance is suffering as a result. AI offers fresh promises and new revenue.
Many investors will happily bite. If you have any doubt, look at the evolution of the ETF industry. It started three decades ago with a fund that tracks the S&P 500 Index. Now it’s a sprawling casino with thousands of funds that are just as likely to be an expensive levered or short bet on some micro corner of the market than a low-cost market tracker. The original S&P 500 ETF has an expense ratio of 0.09%. The average ETF charges more than six times that, and few of them will outpace the mighty S&P 500 over time.
It’s not just the ETF industry. When it comes to money, technology has enabled more vice than virtue. Young investors are betting on crypto, politics and meme stocks, and trading platforms are making a fortune on them. It’s far less profitable to encourage people to save regularly and invest in low-cost index funds. Which path do you reckon AI will take?
AI may have one benefit for index investors: Maybe they won’t have to listen to stock pickers yap about how index funds are making markets less efficient and causing stocks to be mispriced. Soon enough, AI will provide an ample supply of bots that can comb through financial statements and stamp prices on stocks, and probably more quickly and accurately than analysts can do. That should allow sensible investors to own their index funds in peace.
None of this is a knock on AI generally. I have no doubt it will be hugely consequential across many fields. I’m equally confident that fund managers who harness AI will make money whether they beat the market or not. But I suspect most investors who pay high rents for the attempt won’t be as fortunate.
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