A few years ago, as the chief risk officer at an Asian alternative investments firm, Scott Treloar found himself in an unexpected situation.
The company, which had been managing over US$5 billion, was trying to raise capital for hedge funds. Treloar thought it would be a breeze.
Much to his surprise, no one was interested – and they failed to raise any money.
Investors said they weren’t keen on hedge funds, as those had been performing poorly for the past decade. In 2019, fund managers underperformed in the S&P 500 Index – a commonly used benchmark – for the ninth consecutive year.
Hedge funds manage approximately US$3.2 trillion on behalf of investors, according to the 2018 Preqin Global Hedge Fund Report.
However, the investment management industry is facing several challenges: margins are thinning, and rising compliance costs due to more stringent regulations are eating into returns.
In response, hedge funds would typically cut costs and play it safe instead of reexamining their business model. An example would be prioritizing passive over active investments.
Passive investment involves a buy-and-hold mentality that doesn’t require reading the stock market’s every movement. In contrast, an active strategy is more hands-on, trying to beat the stock market through rapid buying and selling in order to take advantage of price fluctuations.
The industry is also encountering another problem: money hasn’t been flowing to the best-performing funds.
Historically, smaller hedge funds have been shown to outperform their larger counterparts.
A June 2017 report by Preqin indicated that emerging managers – first-time funds with track records of three years or less – saw annualized returns of 12.2%, compared to 7.7% for all hedge funds.
Many smaller funds specialize in certain markets or products, and often have more in-depth knowledge of those than bigger, generalist funds do.
However, institutional investors, which typically manage billions of dollars in assets, tend to invest only in large funds due to risk management mandates—a practice that persists despite the fact that these generalist funds perform more poorly than their smaller counterparts. As a result, institutions lose out on the chance to generate better returns, and smaller funds are deprived of access to a larger pool of capital.
In Treloar’s view, these smaller funds, which are often active investors, are the key to a better alpha: an investing strategy’s “ability to beat the market”. An investment’s alpha is its excess return on investment relative to a benchmark or market index, such as the S&P 500.
“These emerging managers are more nimble, more aligned with investors, and are often using newer and more innovative approaches and technologies,” says Treloar.
“There are many pockets of alpha available to investors, but these pockets are smaller and more transient now. So, to get access to alpha, we needed to focus on the smaller hedge funds, differentiate the high-quality smaller hedge funds from the low-quality ones, and also build a business model that solves the cost problems for these high-quality smaller funds,” he says.
Another current challenge for investment management is how its traditional business model lacks transparency. Investment managers typically have privileged access to information that guides investing strategies.
However, today’s investors are demanding better data reporting through digital tools, as well as more knowledge about the performance of investment products.
Finding a better way
In general, investment managers have been slow to adapt to new paradigms. “The industry is inefficient and behind when it comes to the use of tech to reduce costs and improve outcomes,” says Treloar, who was an associate director at Macquarie Bank and a director of models at methodologies at Deutsche Bank.
So, he left the investment management company where he worked, and in September 2016 founded Noviscient: an investment management platform that identifies top investment managers at boutique funds and helps them access large pools of capital.
To address the industry’s challenges and adapt to changing trends, Noviscient developed an “open investment management” approach.
“The future of the industry will be a network of specialists focusing on alpha generators and partnering with a platform like ours for the trading infrastructure and capital raising. The current vertically integrated model where managers have to do everything from identifying alpha to operations, compliance, regulatory management, and capital raising is costly and inefficient,” Treloar explains.
The startup says its approach is seeing an annualized return of 19.8%, with a Sharpe ratio of 2.0 (which is considered good) and a maximum drawdown of less than 5%. The Sharpe ratio is a measure of risk versus return, while drawdown refers to the decline of an investment from its peak.
Instead of employing systematic traders, Noviscient partners with them, allowing them to send trading signals via an application programming interface to the Noviscient platform. The platform then uses machine learning techniques to analyze signals from their trading partners and spot the top performers.
Conversely, institutional investors can access Noviscient to transfer capital to the traders who have been proven to consistently generate superior returns. The platform dynamically allocates capital to investment partners based on their performance.
“We don’t run our own strategies,” Treloar reveals. “We aggregate statistics from our partners, who are not big hedge funds with lots of capital.”
To align investors’ and fund managers’ interests, Noviscient focuses on performance incentives, charging a 1% management fee and a 10% performance fee.
Treloar adds that the platform model allows Noviscient to “offer real-time reporting and portfolio transparency for investors” while “keeping operational risk and costs very low.”
Growth and competition
As Noviscient is a young startup, Treloar says it still has room to grow.
The team is currently made of up six people: a chief information officer, a chief revenue officer, a chief technology officer, a developer, and two quantitative analysts.
Treloar estimates that the company will become profitable once its assets under management reach US$50 million. It projects to have US$52 million total assets under management by the end of 2019. In the longer term, it expects to run on a high operating margin of 85%, implying an annual EBIT (earnings before interest and taxes) of US$100 million.
With automation penetrating investment management, however, Noviscient isn’t alone in trying to shake up the industry. Kavout, a US-based startup, uses an AI-driven investment platform to generate alpha.
The likes of Kavout and Noviscient may also find competition from traditional asset managers that are embracing AI and big data.
A prominent example is BlackRock, a large investment management company, which has made its Aladdin portfolio and risk management platform available to both institutional and individual investors. The platform employs machine learning with the goal of delivering alpha-generating results.
A survey by Element22, cited by McKinsey, found that “large asset managers were spending around US$10 million a year on artificial intelligence and alternative data.” The biggest players in the industry were spending an even larger amount, the survey reported.
The road ahead
For Noviscient, one way forward is to uncover even more high-performing trading groups. Treloar is specifically looking at doing this in China within the next two years, noting that the country has plenty of high-performing financial professionals, as well as a large amount of capital.
The startup is also partnering with other investment service or technology providers. One such company aggregates alternative investment data to develop alpha trading strategies. Another is a deep AI group with around 50 PhDs focusing on various aspects of machine learning, including in the financial services vertical. “We offer them a way to monetize their deep IP and capabilities in the financial markets,” says Treloar.
Earlier this year, Noviscient was selected as one of eight startups to join the Copenhagen Fintech Accelerator: a six-month mentoring program that aims to bring international startups to Denmark.
The program grants up to US$67,800 in pre-seed funding to the chosen startups, as well as access to corporate partnerships.
“We are now looking to raise capital for our flagship Pure Alpha fund as well as a small amount to working capital to help accelerate the growth of our business,” says Treloar. “The results from allocating to our first set of emerging managers are outstanding, and we only expect that to improve with time and as we bring on more emerging managers onto the platform.”