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The investment industry has evolved dramatically over the last several decades and continues to do so amid increased competition, technological advances, and a challenging economic environment. In this article, we will review several key trends that have shaped the investment environment in general, and the context for algorithmic trading more specifically.

This article is an excerpt taken from the book ‘Hands on Machine Learning for algorithmic trading’ written by Stefan Jansen. The book explores the strategic perspective, conceptual understanding, and practical tools to add value from applying ML to the trading and investment process.

The trends that have propelled algorithmic trading and ML to current prominence include:

  • Changes in the market microstructure, such as the spread of electronic trading and the integration of markets across asset classes and geographies
  • The development of investment strategies framed in terms of risk-factor exposure, as opposed to asset classes
  • The revolutions in computing power, data-generation and management, and analytic methods
  • The outperformance of the pioneers in algorithmic traders relative to human, discretionary investors

In addition, the financial crises of 2001 and 2008 have affected how investors approach diversification and risk management and have given rise to low-cost passive investment vehicles in the form of exchange-traded funds (ETFs). Amid low yield and low volatility after the 2008 crisis, cost-conscious investors shifted $2 trillion from actively-managed mutual funds into passively managed ETFs. Competitive pressure is also reflected in lower hedge fund fees that dropped from the traditional 2% annual management fee and 20% take of profits to an average of 1.48% and 17.4%, respectively, in 2017.

Let’s have a look at how ML has come to play a strategic role in algorithmic trading.

Factor investing and smart beta funds

The return provided by an asset is a function of the uncertainty or risk associated with financial investment. An equity investment implies, for example, assuming a company’s business risk, and a bond investment implies assuming default risk.

To the extent that specific risk characteristics predict returns, identifying and forecasting the behavior of these risk factors becomes a primary focus when designing an investment strategy. It yields valuable trading signals and is the key to superior active-management results. The industry’s understanding of risk factors has evolved very substantially over time and has impacted how ML is used for algorithmic trading.

Modern Portfolio Theory (MPT) introduced the distinction between idiosyncratic and systematic sources of risk for a given asset. Idiosyncratic risk can be eliminated through diversification, but systematic risk cannot. In the early 1960s, the Capital Asset Pricing Model (CAPM) identified a single factor driving all asset returns: the return on the market portfolio in excess of T-bills. The market portfolio consisted of all tradable securities, weighted by their market value. The systematic exposure of an asset to the market is measured by beta, which is the correlation between the returns of the asset and the market portfolio.

The recognition that the risk of an asset does not depend on the asset in isolation, but rather how it moves relative to other assets, and the market as a whole, was a major conceptual breakthrough. In other words, assets do not earn a risk premium because of their specific, idiosyncratic characteristics, but because of their exposure to underlying factor risks.

However, a large body of academic literature and long investing experience have disproved the CAPM prediction that asset risk premiums depend only on their exposure to a single factor measured by the asset’s beta. Instead, numerous additional risk factors have since been discovered. A factor is a quantifiable signal, attribute, or any variable that has historically correlated with future stock returns and is expected to remain correlated in future.

These risk factors were labeled anomalies since they contradicted the Efficient Market Hypothesis (EMH), which sustained that market equilibrium would always price securities according to the CAPM so that no other factors should have predictive power. The economic theory behind factors can be either rational, where factor risk premiums compensate for low returns during bad times, or behavioral, where agents fail to arbitrage away excess returns.

Well-known anomalies include the value, size, and momentum effects that help predict returns while controlling for the CAPM market factor. The size effect rests on small firms systematically outperforming large firms, discovered by Banz (1981) and Reinganum (1981). The value effect (Basu 1982) states that firms with low valuation metrics outperform. It suggests that firms with low price multiples, such as the price-to-earnings or the price-to-book ratios, perform better than their more expensive peers (as suggested by the inventors of value investing, Benjamin Graham and David Dodd, and popularized by Warren Buffet).

The momentum effect, discovered in the late 1980s by, among others, Clifford Asness, the founding partner of AQR, states that stocks with good momentum, in terms of recent 6-12 month returns, have higher returns going forward than poor momentum stocks with similar market risk. Researchers also found that value and momentum factors explain returns for stocks outside the US, as well as for other asset classes, such as bonds, currencies, and commodities, and additional risk factors.

In fixed income, the value strategy is called riding the yield curve and is a form of the duration premium. In commodities, it is called the roll return, with a positive return for an upward-sloping futures curve and a negative return otherwise. In foreign exchange, the value strategy is called carry.

There is also an illiquidity premium. Securities that are more illiquid trade at low prices and have high average excess returns, relative to their more liquid counterparts. Bonds with higher default risk tend to have higher returns on average, reflecting a credit risk premium. Since investors are willing to pay for insurance against high volatility when returns tend to crash, sellers of volatility protection in options markets tend to earn high returns.

Multifactor models define risks in broader and more diverse terms than just the market portfolio. In 1976, Stephen Ross proposed arbitrage pricing theory, which asserted that investors are compensated for multiple systematic sources of risk that cannot be diversified away. The three most important macro factors are growth, inflation, and volatility, in addition to productivity, demographic, and political risk. In 1992, Eugene Fama and Kenneth French combined the equity risk factors’ size and value with a market factor into a single model that better explained cross-sectional stock returns. They later added a model that also included bond risk factors to simultaneously explain returns for both asset classes.

A particularly attractive aspect of risk factors is their low or negative correlation. Value and momentum risk factors, for instance, are negatively correlated, reducing the risk and increasing risk-adjusted returns above and beyond the benefit implied by the risk factors. Furthermore, using leverage and long-short strategies, factor strategies can be combined into market-neutral approaches. The combination of long positions in securities exposed to positive risks with underweight or short positions in the securities exposed to negative risks allows for the collection of dynamic risk premiums.

As a result, the factors that explained returns above and beyond the CAPM were incorporated into investment styles that tilt portfolios in favor of one or more factors, and assets began to migrate into factor-based portfolios. The 2008 financial crisis underlined how asset-class labels could be highly misleading and create a false sense of diversification when investors do not look at the underlying factor risks, as asset classes came crashing down together.

Over the past several decades, quantitative factor investing has evolved from a simple approach based on two or three styles to multifactor smart or exotic beta products. Smart beta funds have crossed $1 trillion AUM in 2017, testifying to the popularity of the hybrid investment strategy that combines active and passive management. Smart beta funds take a passive strategy but modify it according to one or more factors, such as cheaper stocks or screening them according to dividend payouts, to generate better returns. This growth has coincided with increasing criticism of the high fees charged by traditional active managers as well as heightened scrutiny of their performance.

The ongoing discovery and successful forecasting of risk factors that, either individually or in combination with other risk factors, significantly impact future asset returns across asset classes is a key driver of the surge in ML in the investment industry.

Algorithmic pioneers outperform humans at scale

The track record and growth of Assets Under Management (AUM) of firms that spearheaded algorithmic trading has played a key role in generating investor interest and subsequent industry efforts to replicate their success. Systematic funds differ from HFT in that trades may be held significantly longer while seeking to exploit arbitrage opportunities as opposed to advantages from sheer speed.

Systematic strategies that mostly or exclusively rely on algorithmic decision-making were most famously introduced by mathematician James Simons who founded Renaissance Technologies in 1982 and built it into the premier quant firm. Its secretive Medallion Fund, which is closed to outsiders, has earned an estimated annualized return of 35% since 1982.

DE Shaw, Citadel, and Two Sigma, three of the most prominent quantitative hedge funds that use systematic strategies based on algorithms, rose to the all-time top-20 performers for the first time in 2017 in terms of total dollars earned for investors, after fees, and since inception.

DE Shaw, founded in 1988 with $47 billion AUM in 2018 joined the list at number 3. Citadel started in 1990 by Kenneth Griffin, manages $29 billion and ranks 5, and Two Sigma started only in 2001 by DE Shaw alumni John Overdeck and David Siegel, has grown from $8 billion AUM in 2011 to $52 billion in 2018. Bridgewater started in 1975 with over $150 billion AUM, continues to lead due to its Pure Alpha Fund that also incorporates systematic strategies.

Similarly, on the Institutional Investors 2017 Hedge Fund 100 list, five of the top six firms rely largely or completely on computers and trading algorithms to make investment decisions—and all of them have been growing their assets in an otherwise challenging environment. Several quantitatively-focused firms climbed several ranks and in some cases grew their assets by double-digit percentages. Number 2-ranked Applied Quantitative Research (AQR) grew its hedge fund assets 48% in 2017 to $69.7 billion and managed $187.6  billion firm-wide.

Among all hedge funds, ranked by compounded performance over the last three years, the quant-based funds run by Renaissance Technologies achieved ranks 6 and 24, Two Sigma rank 11, D.E. Shaw no 18 and 32, and Citadel ranks 30 and 37. Beyond the top performers, algorithmic strategies have worked well in the last several years. In the past five years, quant-focused hedge funds gained about 5.1% per year while the average hedge fund rose 4.3% per year in the same period.

ML driven funds attract $1 trillion AUM

The familiar three revolutions in computing power, data, and ML methods have made the adoption of systematic, data-driven strategies not only more compelling and cost-effective but a key source of competitive advantage.

As a result, algorithmic approaches are not only finding wider application in the hedge-fund industry that pioneered these strategies but across a broader range of asset managers and even passively-managed vehicles such as ETFs. In particular, predictive analytics using machine learning and algorithmic automation play an increasingly prominent role in all steps of the investment process across asset classes, from idea-generation and research to strategy formulation and portfolio construction, trade execution, and risk management.

Estimates of industry size vary because there is no objective definition of a quantitative or algorithmic fund, and many traditional hedge funds or even mutual funds and ETFs are introducing computer-driven strategies or integrating them into a discretionary environment in a human-plus-machine approach.

Morgan Stanley estimated in 2017 that algorithmic strategies have grown at 15% per year over the past six years and control about $1.5 trillion between hedge funds, mutual funds, and smart beta ETFs. Other reports suggest the quantitative hedge fund industry was about to exceed $1 trillion AUM, nearly doubling its size since 2010 amid outflows from traditional hedge funds. In contrast, total hedge fund industry capital hit $3.21 trillion according to the latest global Hedge Fund Research report.

The market research firm Preqin estimates that almost 1,500 hedge funds make a majority of their trades with help from computer models. Quantitative hedge funds are now responsible for 27% of all US stock trades by investors, up from 14% in 2013. But many use data scientists—or quants—which, in turn, use machines to build large statistical models (WSJ).

In recent years, however, funds have moved toward true ML, where artificially-intelligent systems can analyze large amounts of data at speed and improve themselves through such analyses. Recent examples include Rebellion Research, Sentient, and Aidyia, which rely on evolutionary algorithms and deep learning to devise fully-automatic Artificial Intelligence ( AI)-driven investment platforms.

From the core hedge fund industry, the adoption of algorithmic strategies has spread to mutual funds and even passively-managed exchange-traded funds in the form of smart beta funds, and to discretionary funds in the form of quantamental approaches.

The emergence of quantamental funds

Two distinct approaches have evolved in active investment management: systematic (or quant) and discretionary investing. Systematic approaches rely on algorithms for a repeatable and data-driven approach to identify investment opportunities across many securities; in contrast, a discretionary approach involves an in-depth analysis of a smaller number of securities. These two approaches are becoming more similar to fundamental managers take more data-science-driven approaches.

Even fundamental traders now arm themselves with quantitative techniques, accounting for $55 billion of systematic assets, according to Barclays. Agnostic to specific companies, quantitative funds trade patterns and dynamics across a wide swath of securities. Quants now account for about 17% of total hedge fund assets, data compiled by Barclays shows.

Point72 Asset Management, with $12 billion in assets, has been shifting about half of its portfolio managers to a man-plus-machine approach. Point72 is also investing tens of millions of dollars into a group that analyzes large amounts of alternative data and passes the results on to traders.

Investments in strategic capabilities

Rising investments in related capabilities—technology, data and, most importantly, skilled humans—highlight how significant algorithmic trading using ML has become for competitive advantage, especially in light of the rising popularity of passive, indexed investment vehicles, such as ETFs, since the 2008 financial crisis.

Morgan Stanley noted that only 23% of its quant clients say they are not considering using or not already using ML, down from 44% in 2016.

Guggenheim Partners LLC built what it calls a supercomputing cluster for $1 million at the Lawrence Berkeley National Laboratory in California to help crunch numbers for Guggenheim’s quant investment funds. Electricity for the computers costs another $1 million a year.

AQR is a quantitative investment group that relies on academic research to identify and systematically trade factors that have, over time, proven to beat the broader market. The firm used to eschew the purely computer-powered strategies of quant peers such as Renaissance Technologies or DE Shaw. More recently, however, AQR has begun to seek profitable patterns in markets using ML to parse through novel datasets, such as satellite pictures of shadows cast by oil wells and tankers.

The leading firm BlackRock, with over $5 trillion AUM, also bets on algorithms to beat discretionary fund managers by heavily investing in SAE, a systematic trading firm it acquired during the financial crisis. Franklin Templeton bought Random Forest Capital, a debt-focused, data-led investment company for an undisclosed amount, hoping that its technology can support the wider asset manager.

We looked at how ML plays a role in different industry trends around algorithmic trading. If you want to learn more about design and execution of algorithmic trading strategies, and use cases of ML in algorithmic trading, be sure to check out the book ‘Hands on Machine Learning for algorithmic trading’.

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