Algorithmic Trading, The New Fan Favorite?

"There is nothing permanent except change." -Heraclitus

If you need to find your favorite songs without having to spend hours creating a playlist, use Spotify. If you want to schedule an appointment, ask Google Assistant or Alexa to do it.

And if you want to pick high ROI stocks, go with an AI-powered index fund or ETF! Wait! What? Do you want me to trust artificial intelligence and a bunch of codes (algorithms) to choose the stocks?

Yes, recent data from AI index funds and ETFs supports the above. Unlike computer-based trading that we have seen over the past couple of decades, these algorithmic index funds and ETFs use AI to analyze millions of data points for stock allocation, with zero human interference.

Additionally, the broader ETF and index funds using algorithmic investing/trading are benefitting from the use of technology against their human counterparts. We’ll analyze how AI is redefining investing in modern times, and how index funds/ETFs are growing their share in the overall investment industry.

What you didn’t know about modern AI/algorithmic index funds

Let’s take our discussion from hypothesis to hard facts with some examples.

AIEQ or AI Powered Equity ETF from Equibot is the frontrunner in algorithmic index funds. The net annualized returns of the ETF between October 2017 and July 2019 stood at 9.29% against 9.36% returns offered by the S&P 500. It might have fallen a little short of the S&P 500, but the returns are promising nonetheless.

According to Sam Masucci, CEO of ETF Managers Group, which manages AIEQ, “Literally it’s looking at 6,000 stocks every single day, millions of pieces of information to whittle that down to a portfolio of 75 to 100 stocks.” It’d take at least 1,000 research analysts to do such in-depth analysis on a daily basis.

While some may argue that quant funds are nothing new, AIEQ and similar AI-based ETFs/funds are nothing like quant funds. Quant funds use algorithms, data sets to identify critical information, which is then used by a team of stock pickers or fund managers to create a portfolio. AIEQ, on the other hand, uses AI to select stocks based on millions of pieces of information. Some experts favor AI because of its ability to ignore emotional biases in trading.

It is important to note that using AI to make all the calls in investing is a relatively new concept, so it will take a couple of years to understand the complete scope of these funds. One must make an apple to apple comparison while choosing between traditional funds and AI-powered ETFs.

Not just AI funds, but Index Funds are doing good as well

In addition to the introduction and fair run of AI funds, the entire market is, apparently, moving towards algorithmic trading and passive investing, as shown in a recent report. More than 35% of the US stock markets are being run by computer-managed funds, including index funds, ETFs, and quant funds, surpassing human managers, such as hedge funds and mutual funds, that manage only 24% of American public equities.

It might come as a surprise to some that roughly half of the $18trn to $19trn managed funds are under the management of index funds, and for the right reasons. A report from Vanguard indicates that index funds have outperformed actively-managed funds since 1976. In fact, market leaders, including the likes of BlackRock Inc., are favoring passively-managed funds over their actively-managed counterparts.

Index funds aim for a simple outcome, to match the returns of a market index, such as the S&P 500. Active funds, on the contrary, look to outperform the market, which is nothing but challenging, especially when you are looking at year-over-year returns. As an individual investor, you should consider multiple factors before choosing an investment instrument or strategy. Let’s find out more about these investments before making a decision.

Choosing between traditional stocks, ETFs, and mutual funds

Traditional Stocks

The Good: Investing in stocks is one of the easiest and conventional modes of investing. The ease of purchasing, selling stocks is unmatched when compared with other investment instruments. Buying the share of a company (imaging buying Google, Amazon, Coca Cola, AT&T 15 years ago) at the right time could yield excellent results.

The Bad: A bad market could literally wipe out years of gains in an instant. There is no protection against market volatility. An investor has to rely on his research or expert advice for stock investments.

Risk & Reward: Individual stocks come with a high-risk profile. It is good to diversify your stock holdings across different sectors.

Index Funds & ETFs

The Good: Index funds and ETFs come with exceptionally low expense ratios (average expense ratio of 0.09%), which allows investors to book long-term gains. Investing $1,000 in an index fund or ETF could yield $99,000 in 30 years, with an average annual return of 7% against $86,000 in mutual funds.

The Bad: Since index funds and ETFs track broad markets, there is little downside protection under volatile market conditions. Additionally, transaction costs for ETFs could add up quickly.

Risk & Reward: Index funds come with a moderate risk profile, except thematic or industry-specific funds, as they track an entire index. They are suitable for long-term investors.

Mutual Funds

The Good: Mutual funds are led by professional wealth managers with excellent investment track records. The actively managed nature of mutual funds allows fund managers to benefit from a positive trading environment and limit losses in case of a downward rally.

The Bad: When compared with index funds, mutual funds come with a higher expense ratio. Research indicates that index funds outperform actively-managed funds in the longer run.

Risk & Reward: The risk profile of mutual funds vary in accordance with the portfolio. Investors can choose a fund with a high, moderate, or low-risk profile.

The Bottom Line

As an investor, you should look at your personal financial goals before creating an investment strategy. It is good to leverage technology when it comes to investing, but make sure to analyze the risk/reward ratio before making any commitments.


© 2019 by Jacob C Reeves, The Broke Broker.