Machine learning set to shake up equity hedge funds

Machine learning poses a threat to equity hedge funds within the next decade as the technique becomes powerful enough to forecast market moves better than humans, one of the earliest investors in the industry is forecasting.

Jeff Tarrant, the founder of Protégé Partners, says that the model of hedge funds charging “2 and 20” — a 2 per cent management fee and 20 per cent performance fee — for investing in large-cap stocks rising and falling “doesn’t work any more” and is ripe for disruption.

He pointed to the overhaul of other industries in the past decade at the hands of engineers and scientists.

“Jeff Bezos picked off the bookstore business. Apple totally picked off the music business and Netflix totally changed television. Now [machine learning] is going to pick off the hedge funds.”

To back up that theory, he is launching a business that will invest solely in start-up investment funds that employ artificial intelligence. Protégé’s new business, dubbed Mov37, will invest in as many as 10 managers through either seeding them or investing directly, and is targeting total investments of up to $1bn. While many of the biggest systematic hedge funds, which use computer algorithms to make trading decisions, have already started employing machine learning techniques, Mr Tarrant believes it is the young emerging managers who will succeed in disruption.

The excitement over the potential for AI fields like machine learning to unlock lucrative patterns in the swelling sea of “Big Data” comes as money floods into computer-driven hedge funds, while the rest of the industry struggles with middling performance and outflows. Live event What will we do when machines do everything? Join us on June 19th for a conversation about automation and what it means for the future world of work.

Mr Tarrant, who formed Protégé Partners in 2002 to invest in and seed emerging managers, has worked in the hedge fund industry for more than 30 years. He worked for funds including Berkeley Asset Management, co-managing one of the earliest fund of hedge funds, which invested in managers including John Henry and Louis Bacon.

So-called “quantitative” hedge funds notched up their eighth straight year of client inflows in 2016, doubling their assets from 2009 to $918bn, according to Hedge Fund Research, a data provider.

AI is an important, even necessary tool to parse through the vast reams of digital data the world now produces. IDC estimates that the amount of digital data will reach 44 zettabytes (trillions of gigabytes) by 2020, an amount so big that if it was all put in iPad Air tablets, the stack would reach from earth to the moon more than six times over. Eric Schmidt, executive chairman of Alphabet, Google’s parent company, told a crowd of hedge fund managers last week that he believes that in 50 years, no trading will be done without computers dissecting data and market signals. “I’m looking forward to the start-ups that are formed to do machine learning against trading, to see if the kind of pattern recognition I’m describing can do better than the traditional linear regression algorithms of the quants,” he added. “Many people in my industry think that’s amenable to a new form of trading.”