Artificial intelligence (AI) has broken business models, disrupted industries and caused a seismic shift in stock markets between the perceived winners and losers of the new technology.
But one area that it is not ready to take over is the management of passive funds, according to Dale Brooksbank, head of global equity, Europe, at Vanguard. “We're not there yet,” he said.
He conceded that it is possible to create a programme using AI that could, in theory, replicate an index fund. However, he noted that there is “much more to index investing”, adding that it “isn't passive”.
“Index investing comes with a huge number of decisions that you need to make, broadly on a daily basis,” he said, whether it be how to interpret different corporate actions, whether changes need to be made or how often to rebalance. Each fund has its own methodology and therefore will act differently to another.
Even if AI can completely replicate the methodology of a particular index fund, Brooksbank argued that the end investor would still be worse off if investing in one run by an experienced firm such as Vanguard, such as the Vanguard S&P 500 fund, which will market its 50th year at the end of August.
This is because the AI index replica likely won’t take into account any tax implications, trading costs and other factors that go into managing an index fund.
That is not to say that people won’t try. Brooksbank suggested that within the next two-to-three years there will be a strategy created that is run in totality by AI.
“Whether or not it's the right thing for investors is a different question,” said Brooksbank. “I've also worked in this industry long enough to have seen [it all].”
He used Knight Capital – formerly Knight Trading – as an example. In August 2012, a software error at the firm flooded the market with unintended orders, causing a loss that the company put at around $440-460m and forcing an emergency financing deal within days to keep the firm afloat.
The episode highlighted that one misplaced trade can lead to dire consequences for investors, which is why the firm places a huge emphasis on stewardship.
“First and foremost, the human element and stewardship of our clients' assets comes above everything else,” Brooksbank said.
That is not to say that new technology will be useless in the index-investing sphere. He noted that there are several ways new tech is making the index fund market more efficient, from tokenisation to the blockchain, as well as the use of AI in portfolio analysis.
“All of these things may influence, through time, how we think about the lifecycle of portfolio management and trading,” said Brooksbank, who added that Vanguard is working “in the background” to innovate its processes and assess where automation can add improvements.
Another common concern at present is the market concentration, forcing index funds to buy vast amounts of stock in a narrow group of companies, such as the Magnificent Seven in the US and the semiconductor names in Asia and the emerging markets.
However, Brooksbank dismissed this. "As much as you're reflecting today's winners, within a broad diversified index, you've also got yesterday and tomorrow's winners as well,” he said.
“So it's not just one thing to say you're tracking what today's winners are. Actually, it [an index fund] reflects a broad church of successful companies, but also potential and future winners as well.
“That's the beauty of diversification, right? Don't buy the needle, buy the haystack.”
Index fund providers must provide choice to investors, however, who need to be able to construct portfolios in whichever way they choose. On this front, Vanguard launched three global equity ETFs last week to expand its range.
This builds on the roll-out of four new US funds launched in July, including the Vanguard Russell 2000 U.S. Small-Cap UCITS ETF and Vanguard Russell U.S. Mid-Cap UCITS ETF.
“That's why we offer a range of different funds,” Brooksbank said, noting that the firm has focused mainly on “core exposures” such as global and regional equity trackers.
“What you won’t see us [create] is something we don’t believe has a great investment thesis behind it, or that might not be appropriate in terms of what we think will be additive for investors,” he said.
For areas where the firm does not have passive products, Brooksbank suggested active management is the answer. The firm is one of the world’s largest active managers, with the head of global equity for Europe noting “there is always a place for active to be able to deliver for clients”.
“For great active managers there's a place in the ecosystem. And there always has been. Those people have delivered consistently for investors and I think that coexistence is absolutely fundamental,” he said.