Neural networks invade hedge fund industry

Imagine a mathematical system that works like a human brain, can absorb thousands of bits of information in seconds, learn from its mistakes, adapt to new environments and help a manager allocate money to hedge funds.
No, it's not Hal from the film 2001 Space Odessey or the Terminator, a robot played by Arnold Schwarzenegger - both artificial intelligence tools that learned human behaviour.
But it's something similar - a neural network that is being developed by Germany's Commerzbank AG with academics at British universities to earn better risk-adjusted returns for hedge fund investors. The model will aim to analyse all available information real-time to highlight any potential problems that could damage investment returns.
Commerzbank's head of alternative investment strategies, Mehraj Mattoo told Reuters this week that the traditional way of creating a portfolio of hedge funds was flawed because it relies on history. "A lot of the models used in the fund of funds world, indeed in finance generally, are flawed because they rely on history as if it was both static and repeatable. If history was such a good gauge then we would all be making money," Mattoo said.
"Other information such as economic conditions is ignored to keep things simple. A neural network - obviously derived from the biological analogy - tries to take everything into account and learn as it goes along." Commerzbank's hedge fund businesses have nearly $1 billion under management.
The flow of money to funds of hedge funds, which invest in diversified portfolios of hedge funds to cut the risks, has slowed as their returns slipped to around 5 percent last year, little more than investors could have earned on money markets.
According to data complied by Commerzbank, new money going to funds of hedge funds slowed to around $36 billion last year compared with $65 billion in 2004, $86 billion in 2003 and $104 billion in 2002.
Funds of hedge funds still control about one-third of the $1.5 trillion estimated to be invested in the industry, but to survive they will have to be more innovative. The traditional fund of hedge funds offering is often based on subjective factors with only lipservice paid to an analytical objective approach, Mattoo said. "Added to that there has been a lack of active management once portfolios are created for fear of disturbing cosy relationships."
One of the problems investors have with hedge funds is working out whether a manager has strayed beyond his mandate, for example investing in emerging markets when the brief was for Western Europe only - the so-called style drift.