Fears have been mounting in recent years over the precipitous rise of computerized, or algorithmic, trading systems. The “algos” have become something of a boogeyman, taking the blame for all manner of market ills.
Many value investors - and a host of active investment managers across a range of strategies - have lambasted the rise of the algos. But are they being unfair to computers? There is reason to believe at least some of the fears are overblown.
The fund manager’s lament
The computerized models have certainly been growing, with quantitative strategies gaining increasing traction. It is not just high-frequency trading firms. Many index funds also rely on computerized strategies to manage rapid, large-scale rebalancing.
These changes to fundamental infrastructure of the market have rarely received sufficient appreciation, but money managers and traditional investors have been forced to come to grips with a new reality. Of course, it has not been easy for many investors to adapt. Stanley Druckenmiller (Trades, Portfolio), the legendary boss of Duquesne Capital, expressed dismay about the changes in an interview last year:
“These ‘algos’ have taken all the rhythm out of the market, and have become extremely confusing to me.”
Druckenmiller is far from alone. Philippe Jabre, once a high-flying money manager, recently announced his hedge fund will be closing down, blaming computer-driven trading for the decision:
“The last few years have become particularly difficult for active managers. Financial markets have significantly evolved over the past decade, driven by new technologies, and the market itself is becoming more difficult to anticipate as traditional participants are imperceptibly replaced by computerised models.”
Of course, Wall Street masters of the universe are not the only investors who have expressed reservations - or outright hostility - to the computer-driven evolution of the market ecosystem. Value investors have, on average, proven especially hostile toward the algos. The antipathy makes intuitive sense. Value investors, by definition, are looking for bargains and opportunities based on underlying values in the securities they buy and sell.
Algos are in many ways the pure opposite of value investors, philosophically speaking (more so even than their traditional rival tribe, the growth investors). It is thus unsurprising that value investors would find something unsettling about an increasingly computer-driven, automated stock market.
Is the hate overdone?
The condemnation of algos among value seekers and active managers may be overblown. It may also be selfish to a degree. As Bloomberg’s Matt Levine discussed in a recent newsletter, fund managers’ criticisms are often self-serving:
“One issue here is that these are very narrow problems: The fact that some rich people personally find algorithms confusing is not something that I care about. Hedge fund managers don’t—or aren’t supposed to—get tenure; there is nothing unnatural about someone making a lot of money in the olden days and then being out-competed by the next generation.”
By this reading, the natural competition of the market is at work. The old-timers may feel shortchanged, but the real “problem” is their own incapacity to deal with the new reality, not that the new reality is itself flawed. Indeed, as Levine further points out, the inability to profit from inefficiencies ought to be considered a feature, rather than a bug, of the new market structure:
“If markets are easy to anticipate, if they have a predictable rhythm, then that means that they are inefficient, that they do not incorporate all reasonably-easily-available information into prices.”
This is an interesting take, one that will undoubtedly grate the nerves of any active investor. But, writ large, it is a fair conclusion to reach. It might also be applied readily to the sour value investors. A recent short post published by Demonetized highlighted some of the questionable thinking driving fundamental investors’ attitude toward the algos:
“In many circles – particularly those of the fundamental discretionary persuasion–there has emerged a kind of millenarian cult mindset. We endure this suffering to purge our sins. To mortify the flesh. When The Great Reckoning arrives, the Algos and the Indexers and the Risk Parity Heretics shall be cast into the flames. And we, The True Investors, shall emerge from the hellfire unblemished, as did Buffett after the Dot Com Bubble.”
That may sound a tad overdone to be sure, but it does highlight the potential of value investors and their ilk to hate algos unthinkingly.
Verdict
All that being said, we are not convinced the algos are all good. We have previously discussed the potential risks computerized and algorithmic trading might pose to the health of the market, risks we still view as very real.
Computer-driven trading can exacerbate volatility in choppy markets, and their primacy increases the risk (and potential magnitude) of flash crashes. More concerningly, the computer-centric market architecture has yet to be tested in a real downturn. JPMorgan’s (JPM, Financial) head quant is kept up at night by just that fear, so we feel it is worthy of our attention as well.
Still, it is worth considering the other side of the case from time to time. While the computer-centric market architecture is far from the efficiency-creating panacea its boosters claim, it deserves more than mindless antipathy from value investors.
Disclosure: No positions.
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