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Applying predictive analytics in investment management – how investment firms can get ahead

With the growth of computing power combined with the latest in artificial intelligence, machine learning, and now quantum assisted machine learning a quiet revolution is occurring that is changing the way we invest and trade.  Using predictive analytics technology algorithms can now scan vast amounts of data to quickly identify trends and anomalies within financial markets and use those to make investment decisions. However, most investors are behind the game in terms of what they need to do to take advantage of this burgeoning opportunity.

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Protecting against the next potential market crisis…the great unwind

Smart investors are neither bulls nor bears, rather are pragmatists who are always looking to insure against the next crisis. They get nervous if things are going too well. One potential crisis that may been looming is one of the most crowed trades currently in the market – passive equity index investment.

Since the global financial crisis there has been a massive flow of investment into passive funds (a cumulative $1.6 trillion) accompanied by a significant outflow from active funds (outflows of around $400 billion).

Instead of looking for investment opportunities to beat the market, investors are opting to invest passively and in the process, are increasing their vulnerability to a large scale equity market correction.

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Would you be happy with a 20% loss provided you matched the index…

Did not think so, nor would I. However, investors that redeemed $250 billion from active funds and invested $1.3 trillion of assets into passive products as at August 2016 have implicitly agreed to that performance outcome in the event of an equity market correction.

And why wouldn’t they? As we are constantly reminded by the passive fund providers’ marketing teams, passive equity index funds have done very well these past few years whereas many actively managed investment processes have underperformed the major averages.

Much of the research that is published focuses on cost or relative performance of passive investments with very little focus on the main deficiency in passive investment strategies that is its lack of risk management.

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A calm before the storm?

The markets are eerily calm, across most asset classes. The stock markets are not moving much apart from the occasional pull backs and implied volatility remains stubbornly low. Bonds are consolidating and oil seems to pivot around the $50 per barrel mark.

All eyes are on the upcoming US election and polls are indicating a Clinton victory. However the danger is in a shock outcome. In its complacency the financial system is positioned for a major shock if the unexpected happens. If the polls are wrong or if something surprising changes the dynamics, the response in financial markets could be devastating to investors.

I believe the probability of Trump winning is low. Then again many thought Britain would vote to stay in the European Union. It is my view that the risks are asymmetrically skewed to the downside.

Common sense risk management would suggest scale back risks going into the final days. If there is a non-Trump victory, the market moves are likely to be small and investors will not have missed much of the upside. Consider the missed gains as a cheap option to protect the portfolio.

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The obsession with short term stock price performance can only end in tears….

Given the pressures faced by corporate executives and investment managers, the constant flow of information only appears to have heightened the obsession with short-term stock price performance at the expense of longer-term goals.

One change that I have observed is that future expectations seem to be having a diminishing influence on stock prices.