Why The Perfect AI Hedge Fund Doesn't Exist
Creating the ultimate trading machine hasn't been perfected, with most AI funds actually underperforming.
Artificial intelligence (AI) is definitely going to appear on the bingo sheet for top words of 2023. While the focus has been on Nvidia and other tech names pushing the frontiers in this capacity, investing and trading has been putting AI to use for several years.
Granted, it’s an ever evolving phrase that encompasses more and more. But on the face of it, it doesn’t seem like the finance world has quite mastered the art of AI and profit generation.
Evidence of this can be seen from the below returns over the past few years of AI hedge funds versus the main index:
How funds are using AI
There’s a huge spectrum of uses of AI in trading right now. For example, we wrote back in April about J.P Morgan releasing an AI model that poured over Fedspeak to try and assign probabilities related to monetary policy actions:
JP Morgan Has A New AI Trading Model...And It's Good
The Hawk-Dove Score analyses language from Fed officials and rates it as hawkish or dovish. It then can provide a trading signal in the lead up to the next Fed meeting, if there’s a mismatch in language versus expectations. Although unlikely to be made available to the public, we flag up other trading models that do work.
Another angle of AI is in more traditional quant modelling. At it’s most basic form, you could be forgiven for saying that a quant trading strategy is a quasi-form of AI. These type of funds have been around for decades.
Further, AI can be used not to actively trade, but rather to cut out the pre-trade research. The ability for it to digest information via machine learning can eliminate hundreds of manual hours of research done by analysts instead.
Yet the more recent nuance is tweaking quant models to include deep-learning elements. While a quant model could say “buy a stock if earnings per share are greater than X”, deep learning could figure out that this only works in some areas of the market, or factor in broader market sentiment and expectations.
The levels to this can be noted in the below graphic.
For the rest of this article, we’ll discuss:
The 3 major reasons why the average AI hedge fund underperforms
The top funds that are worth watching for the future
Reasons for underperformance
We identify three main reasons for AI funds dragging their feet.
1, Noisy Markets