AI might eventually suggest that we all invest in inexpensive index funds.
Although artificial intelligence is a very effective tool for investing, human-run investment management is still superior.
This is the reason: It’s possible that one investing firm could outperform the market if it were the only one of its Wall Street rivals using AI. However, the mathematics of active management ensures that the ordinary manager will fall behind the market when almost all businesses use the technology, which is becoming the case.
According to a survey done last year by the fintech company Broadridge Financial Solutions, the number of businesses using AI has increased dramatically. Executives from two out of three companies surveyed said they “use [generative AI] most for investment or market research.”
My allusion to “The Arithmetic of Active Management” refers to a well-known piece by the same name written by William Sharpe, the economics Nobel laureate in 1990. This conclusion is based “only on the laws of addition, subtraction, multiplication, and division. Nothing else is required.” He demonstrated in that paper why active managers, on average, must lag broad market indexes. This is due to the fact that outperforming the market is a zero-sum game prior to transaction expenses and a negative-sum game following them.
The information backs up Sharpe’s claim. The Eurekahedge AI Hedge Fund Index is “designed to provide a broad measure of the performance of underlying hedge-fund managers who utilize artificial intelligence and machine-learning theory in their trading processes.” Let’s start by looking at the index’s performance. The index was 23 percentage points behind the S&P 500 SPX for trailing one-year returns, 11 percentage points below trailing five-year returns, and 8 percentage points behind trailing ten-year returns when it ceased updating in January of this year.
Actively managed U.S. large-cap mutual funds and exchange-traded funds (ETFs) provide further data. Given Wall Street’s growing adoption of AI, we would anticipate that the proportion of these funds using it to outperform the market would have increased in recent years.
However, as the following figure shows, the industry has not performed any better as a result of this increased use of AI. For instance, the proportion of funds outperforming the market in 2024 was just lower than the average of 36% since 2001, at 35%.
The performance of the few funds that not only use AI but also claim to be basing their strategy on it provides more evidence supporting the same conclusion. The table below shows that just a small percentage of these funds have outperformed the S&P 500.
The U.S. equities funds that advertise that they are based on AI are not all included in this table. However, there are enough funds on the list to support my claim that using AI to win the market is not a guaranteed strategy.
Does AI have creativity?
The ability of AI to think creatively is crucial to comprehending its potential. Stated differently, is it capable of generating investing strategies that have never been considered or even imagined?
Lawrence Tint acknowledged in an interview that some managers with knowledge of AI might one day outperform the market. Tint, who was Sharpe’s colleague when he authored the article on the arithmetic of active management, was the former U.S. chief executive of BGI, the company that founded iShares (now a part of BlackRock (BLK)).
According to Tint, AI’s ability to outperform the market will be constrained if it is genuinely inventive. This is due to the fact that the majority of big Wall Street companies will find strategies that are momentarily effective for a certain management, and eventually that manager’s edge will be challenged.
At that moment, an AI-using company’s only chance will be to keep at least one step ahead of other AI-using companies. That may be a remote possibility because any advantage would be short-lived due to the growing speed and strength of AI systems. According to Tint, if AI is creative, one potential outcome could be that it suggests that we all invest in inexpensive index funds.
Tint went on to say that if AI lacks creativity and is only a strong search engine for existing knowledge, then it could be able to outperform the market if it were in the hands of a truly innovative genius. Ironically, though, it will be the creative genius who understands how to use AI “to better implement the concepts that the genius came up with, and to find ways to shield the concepts from other AI firms,” Tint said, rather than AI outperforming the market.
Keep in mind that the question Tint is posing regarding creativity is not the same as the question of whether AI is intelligent enough to replace humans or if it has already done so, as OpenAI creator Sam Altman suggests. When comparing AI to human capabilities, some people think of “intelligence” as the effective synthesis of existing knowledge. That’s not the same as the true creativity required to create something entirely original.
The bottom line? Despite AI’s strength, using it does not and cannot ensure that you will outperform the competition. Limit your expectations because it will never be easy to outperform the market.
