Two Saturdays ago, a Barron’s article addressed the use of artificial intelligence in managing investment portfolios and how soon human portfolio managers would be replaced. Given our role in the world – as PMs — you might not be surprised that the headline caught our attention. However, the article went on to discuss how disappointing the AI-driven investment experience has been (AI-Powered ETFs Don’t Beat the Broader Market) in terms of actual performance.

“Even newly launched or repurposed ETFs using AI to picks stocks are lagging behind broader markets.” Before we take a victory lap, it’s important to take AI’s underperformance with a grain of salt — we are in the early innings of applying this technology broadly and, as a result, there is a limited data set. However, given that our industry tends to overpromise, overhype and underdeliver as participants fall over themselves to capture asset flows by marketing the “latest and greatest investment idea” – ESG investing, anyone? – we think some skepticism is warranted. Just because the technology is newly available, newly applied, or even novel, doesn’t mean it will be transformative in terms of performance, as reflected the following table:

Even the folks peddling these wares advise caution that these AI funds are meant to complement broad-based market strategies, not replace them. Another rationale is that their process doesn’t really fit neatly into any category, because these funds use AI, not necessarily to beat the market, but to define it. But my favorite excuse of all is that underperformance is likely the fault of the active managers they are trying to replicate. Makes me wonder if humans came up with that one or if AI did.

Go figure!

The “AI will change everything” mantra reminds me of the investment community’s fascination with factor technology starting roughly 10 years ago. Remember factor investing — an investment approach that involves targeting specific drivers of return across asset classes? Remember how back testing uncovered that many factor-based strategies would have materially outperformed active managers and even the equity markets, writ large, over the previous 10-30 years had they actually been in place? And how they were able to replicate any active strategy simply by knowing how that strategy loaded on each factor? Back then, most new products were utilizing this quantitative methodology, and mutual fund and ETF companies were raising billions riding this new wave. And active portfolio managers were being described as obsolete. Then, en masse, it didn’t work — enter multiple years of significant underperformance — so bad, in fact, that most of these strategies were abandoned when ESG came into vogue. This was partly the result of accelerated mass adoption that may have resulted in all the informational value being arbitraged away by efficient markets. But mostly, it was hubris – the idea that one could merely go factor “shopping” to find a collection of Return Predictive Signals (RPS), each which had performed well in the past, but had never been combined and managed real-time.

We use factors but not in the same way. What we do is validate our fundamental judgments to build asset allocation portfolios with ETFs for some of our research clients. In addition, we construct quantitative clones of our fundamental strategies with factors as building blocks to extend our philosophy and process to adjacent areas like concentrated Small Cap Growth. For the most part, while more volatile due to our higher conviction, fewer holdings mentality, these “systematic” portfolios have fared well. But, keep in mind, it was our philosophy and process that drove factor selection and combination as a “best fit” to our fundamental work, not the collection of factors that delivered the most attractive hypothetical results.

We will likely find ways to incorporate AI tools into our work over time–in the same way we use factors today. As a boutique firm doing big things, we are always searching for ways to utilize modern technology – we just want it to make us human portfolio managers smarter not dumber.

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