MassPRIM credits a crucial element of its investment success to a laser focus on controlling costs. Costs, alongside risk and return, comprise three philosophical pillars that shape investment and in the fiscal year 2024 cost saving measures include no-fee co-investments in private equity and direct investments in real estate.

The $96.6 billion Massachusetts Pension Reserves Investment Management Board (MassPRIM) is budgeting for $520.3 million, equivalent to 52.6 basis points, in costs next year. In a recent administration and audit committee meeting, the board heard how the investor’s slightly higher projected fees and expenses are linked to higher average asset levels and a larger allocation to more complex and costly assets that results in higher costs. Next year’s budget has a modest increase of $2.3 million, or 0.4 per cent from the prior year.

MassPRIM credits a crucial element of its investment success to a laser focus on controlling costs. Costs, alongside risk and return, comprise three philosophical pillars that shape investment of the giant PRIT Fund, the pooled retirement fund for Massachusetts teachers and other state employees.

In a balancing act, the increased allocation to higher performing, higher cost, asset classes has to align with a goal to keep expense ratios consistent year over year. The board heard how the investment team are constantly looking for ways to save money and that the fiscal year 2024 budget reflects many of those cost saving measures, such as no-fee co-investments in private equity and direct investments in real estate.

Still, the investment management fees portion of the budget will increase $1.9 million in line with forecast hikes in private equity, real estate and timber fees, increasing in line with projected increases in commitments and acquisitions in those asset classes.

MassPRIM’s budget comprises three pillars – external investment management fees, third-party service providers and internal operations. Of that, investment management fees account for approximately 90 per cent of the total budget, explained Anthony Falzone, deputy executive director and chief operating officer, presenting the draft operating budget. He said the budget doesn’t include performance fees, incentive fees or carried interest as it is extremely difficult to estimate future performance.

The size of any one asset class does not directly relate to the size of the expense, Falzone continued – private alternatives will have higher fee structures than larger allocations in the public markets. “Historically that has been money well spent, specifically in the case of private equity,” he said.

“No one likes to pay high fees but these alternatives are a critical component of MassPRIM’s asset allocation that historically has allowed the PRIT Fund to exceed that 7 per cent actuarial rate of return.”

The board heard that the budget is not necessarily intuitive in that fees often trend in the same direction as asset levels. If asset levels are up fees will normally increase – and growing assets is a good thing.

The fee budget to third-party service providers is decreasing due to lower budgeted PCS platform provider fees and real estate consulting fees, along with cost savings from internal research as the team build out their own data infrastructure. The board heard that the last section of the budget, operations expenses, has increased mainly due to changes in the compensation section to support new hires.

Falzone mentioned the need to continue to look for ways to add transparency and detail to help communicate where MassPRIM is allocating budget. “Additional transparency helps management perform analytics that can aid in measuring where MassPRIM spends,” he said.

Diverse manager costs set to rise In line with mandates

Elsewhere, the board heard how fees paid to diverse managers will increase as the number of diverse managers in the portfolio grows. MassPRIM deployed more than $2.8 billion to diverse managers in 2022, bringing the total to more than $9 billion in line with its award-winning FUTURE Initiative.

MassPrim launched its FUTURE Initiative to comply with 2021 Investment Equity Legislation, championed by Treasurer Goldberg. The Initiative sets goals for MassPRIM to increase the use of diverse investment managers and vendors to at least 20 per cent of total AUM. Alongside allocating capital to diverse managers, the asset manager has promised to reduce barriers to diverse managers, enhance DEI reporting and develop enhanced contract tracking.

MassPRIM  posted a 6 per cent gain for the fiscal year ending June 30, powered by equities. Fixed income continued to struggle, but private market allocations provided ballast in a “stormy environment”, particularly private debt and timberland. MassPRIM is targeting an increase in the private equity target allocation from 12-18 per cent to 13-19 per cent.

In hedge funds, current strategy includes maintaining the allocation to stable value funds and continuing to identify co-investment opportunities. MassPRIM is expanding its presence in multi-PM platforms and their impact on the hedge fund industry, and is also continuing to explore directional funds and sector, country-specialist funds.

The board heard how market downturns create good buying opportunities, and that the team has been busy evaluating opportunities. It has deployed nearly $6 billion in new investments across all asset classes despite markets remaining in a prolonged, volatile period for now.

As the multitude of macro-economic risks influence market conditions in unpredictable and unprecedented ways, CIOs are facing the most challenging and interesting times in their careers. A group of investors came together in London to share their ideas on how to best assess risk and position their funds for both the challenges and opportunities in this increasingly demanding and puzzling market. 

Better risk and liquidity management alongside regional diversification and a bigger focus on operational excellence are key levers for portfolio resilience according to a group of large asset owners who came together in a London boardroom to share ideas. With geopolitics, liquidity concerns and a “pesky inflationary” environment on their minds, there was no shortage of topics to debate. The group focused on how the global economic pressures are impacting investment opportunities and how to position their portfolios for the best possible outcomes, no matter what the environment. Climate pressures, risk and scenario planning, and liquidity management and flexibility were key areas of sharing.

Chair of Universities Superannuation Scheme (USS) and renowned UK economist Kate Barker said inflation is still a key consideration around the strategy table. Barker, who sat on the Bank of England monetary policy committee from 2001 to 2010, said if participants didn’t remember the importance of better monetary and fiscal coordination, “we are all doomed”.

“Central banks will manage to keep inflation under control but it will be more difficult,” she said, warning that real interest rates are a lot higher than most economists estimate. “One of the things about trying to keep control of inflation is I always ask people: where do you think the neutral real interest rate is?” Barker said. “Economists still think it is zero. I don’t think that can possibly be true. We need to think that the neutral rate for the UK is about 3.5 per cent in real terms. Are we ready for that world? We are now making adjustments for that.”

Railpen head of investment strategy and research John Greaves said the fund had been wrestling with the role of bonds in a portfolio given the macro and market volatility and uncertainty. “We’ve had this pesky inflationary environment that has been difficult for investors and we’ve been looking at how to mitigate that risk in portfolios as well as take advantage of it,” he said.

In terms of portfolio resilience, the group – which also included Barclays Pension Fund chief investment officer Tony Broccardo and Norges Bank Investment Management global head of strategy research Frederik Willumsen – discussed the importance of diversification, hedging unwanted risks, organisational robustness, the sustainability of economic models and technology, liquidity, active management and dynamic asset allocation.

Is diversification still a tool for resilience?

GSAM head of UK fiduciary management Ed Francis began the discussion about diversification by asking participants to question whether diversification has delivered what it promised.

“Fundamentally we would still be of the view from an academic perspective if you can get uncorrelated sources of return working together it is better for risk management outcomes over the long term,” he said. “On the flip-side the industry has a complexity bias, and if you’re an agent in the system you do things that are more complicated. We need to control for that bias. There has been a lot of experimentation with things like alternative beta and certain areas of the credit markets and I feel like some of that hasn’t really delivered. Is there a better way?”

GSAM, which partnered Top1000funds.com on the event, recently published a paper, Investing in a high-risk world, suggesting portfolio construction in the current market environment should focus on risk management, liquidity and optimising across public and private assets simultaneously.

Railpen’s Greaves agreed that risk management needs to be a core part of any conversation around diversification.

“Everyone has different measures of risk they focus on. Principally we try to focus on the medium to long horizon with regard to risk management,” he said. “For example the relationship between emerging market debt and equity in the short term is about liquidity and risk aversion and they are highly correlated. In the long term, is whether I get paid back by Mexico related to whether Tesla has an earnings surprise? Probably not. You have to think through the medium-to long-term structural drivers of the portfolio.”

Greaves said regional diversification had probably been under-emphasised by institutional investors and would be more important going forward, as highlighted at the Fiduciary Investors Symposium in Singapore in March.

“We are entering a multi polar world. Regional diversification is a lever that many institutional investors don’t pull very hard,” he said. “A lot of western investors are pulling out of Asia, it feels like that is the wrong way around. I think that regional diversification will be much more important in the future.”

Newly appointed NEST chief investment officer Liz Fernando has been actively building out the fund’s private markets portfolio. “When we think about private markets it’s so we can get access to return streams not available in public markets and to industries and sectors which aren’t coming to public markets until later in their maturity,” Fernando said.

NEST, the £30 billion and fast-growing UK defined contribution fund, first started investing in private credit focusing on middle market lending as a complement to the high yield portfolio. It then moved into infrastructure and renewables as “an amazing opportunity to get capital in the ground and benefit from the energy transition”, Fernando said.

It’s been investing in private equity investing for about a year, with the fund now looking at natural capital, particularly timber, as the next private investment opportunity. “Natural capital is extremely uncorrelated with other asset classes and low volatility, and it fits in with our ESG goals,” she said.

The Church Commissioners for England fund was ahead of the curve in investing in natural capital with a 5 per cent allocation to forestry added to the portfolio in 2011 and producing 15 per cent per annum ever since. It also has a separate 5 per cent allocation to farmland. Church Commissioners chief investment officer Tom Joy told the roundtable his team asks two questions when considering diversification in the portfolio.

“We try to define a role an asset class should play, and then ask if it is reasonable to assume that asset class will be able to fulfil that role,” he said. “They are two different questions. We actually felt we were struggling to talk about resilience back in 2018 when the whole of fixed income, including private credit, was not offering anything like what we needed. So we started a program of building an internal dynamic hedging capability which went completely against the grain of what most people would think. We found it to be a very useful tool. We are not using it much at all now, other than removing foreign exchange hedging.”

We need to think that the neutral rate for the UK is about 3.5 per cent in real terms. Are we ready for that world?

Chris Rule has been involved in building the Local Pension Partnership from inception since becoming inaugural CIO in 2016. He’s now chief executive, and LPPI has been an important player in infrastructure in the UK as the designated manager for GLIL Infrastructure. One of the benefits of infrastructure is its cashflow, and its utility in the context of meeting the pension promise.

“We have embraced infrastructure particularly private infrastructure and harvest the income from that,” Rule said. “We look at 50 per cent of the return to come from yield.”

However, Rule said he is concerned about an emerging gap between the buyer and seller and the impact of that on capital deployment.

“What has been relatively easy to do is to deploy capital into secondary assets,” he said. “That is more challenging today because there is a big gap between seller and buyer. We have significant unallocated capital we are looking to take advantage of. Addressing the demand side of that and bringing efficiency is interesting for us. Double-digit returns and good income is positive, but capital deployment will be the question over the next few years.”

LLPI has benefited from a top down total portfolio view in its asset allocation approach which is something CPP Investments has been doing for some time and is constantly tweaking.

Managing director, public markets in the active investment management group, Romy Shioda, said the fund looks to have a strategic allocation as a collective portfolio and then considers relative value across public and private to achieve the exposures.

“We are now trying to move towards a more centralised approach and have more guidance from the top, as there are lot more correlations and macro factors that drive it. So things like inflation hedging from infrastructure is important,” she said. “We are trying to think of it at a high level and then whether we have a unique edge in public or private to invest, and the bottom-up specialty to deliver the exposures.”

But the risk with a top-down framework, according to Railpen’s Greaves, is the potential introduction of pro-cyclical behaviour.

“We have completely revamped the approach we have for managing illiquid exposures,” he said. “You’ve got to be careful chasing allocations to illiquid assets as markets are rising – particularly if you are a slightly cashflow negative fund like ours. We are telling our illiquid teams we want them to be slightly below target most of the time because we want to have dry powder if markets turn,” he says. “Investing is as much about creating the processes and frameworks to be successful through time as it is coming up with perfect SAA.”

Operational excellence

The worlds of risk, liquidity and operational excellence collided in September 2021 in the UK with the gilts crisis. GSAM’s Francis said the “LDI crisis” highlighted the impact of operational failure and inferior assessments and execution, which may have led to very poor decisions,” he said.

“There were other situations where, for structural reasons, people didn’t have visibility on their positions and had to take action as a result of that. We understand some schemes cut hedges at inopportune times. As time goes by, we are seeing more and more bad stories in the market impacting schemes’ funding levels. High-quality investment operations in that one period [were] really important, perhaps for the first time in history.”

Roundtable participants agreed that it’s not just when a liquidity event happens that operational management is important, it’s important all the time. “Operations matter even outside of a crisis,” said USS’s Barker, with GSAM head of EMEA institutional business Chloe Kipling emphasising the right governance and delegation allows for flexibility and quick decision making.

Participants agreed that investment operations within asset owners was probably under-developed compared to the investment process, with one participant noting that “everyone has a strategy until they get punched in the face”.

“If you got punched in the face last September all bets are off, it didn’t matter what great ideas you had, or new asset classes, you wouldn’t be able to do any of that good stuff because you made a fundamental mistake,” the participant said.

We are entering a multi polar world. Regional diversification is a lever that many institutional investors don’t pull very hard

Creating first-class enterprise risk frameworks is an area of improvement for asset owners, the delegates continued. The back-end and front-end systems should be brought together in a way that allows for smooth execution in the case of the escalation of a crisis.

Liquidity management is as much a discipline as picking stocks or managing a credit portfolio and should be given more priority within pension funds, the roundtable participants heard. Railpen, for example, tries to constantly think about different liquidity scenarios.

“In my experience risk systems are not great at liquidity management, they are only good as the inputs they get,” Greaves said. “With short-term liquidity management you try to model the worst scenarios for your liquidity and make sure have good coverage of those scenarios with cash-like assets, constant monitoring and nimble governance. But then it is thinking about how you top that liquidity back up and from where – the collateral ladder. That’s the more challenging bit. We try and maintain a view on sources of liquidity at all times, so we know exactly what we would do in different scenarios and it all just flows through.

“You can also engineer the strategy itself to put less strain on the liquidity of the assets and that’s a very sensible reaction to the environment we are in. But it comes at a cost to expected risk and return.”

The fundamentals of risk management and other tools used by investors may become even more relevant, but there was a belief around the table that there is a need to think more deeply about scenarios. Scenario analysis done well can give investors insights into behaviour and preferences of their stakeholders. LPPI’s Rule gave an example of a recent exercise with the fund’s investment committee.

“Scenario analysis can feel a little bit theoretical,” he said. “We wanted to give our IC something more tangible, so we did a red-team and blue-team exercise where we had our investment team gradually feed in the outcome of scenario analysis into the IC and they then discussed the information and what decisions they wanted to take.

“That was quite interesting, seeing the habits the IC developed as they started living through those scenarios, and what we saw was every single time they reached for liquidity.”

“Every time, they wanted more flexibility and agility to have a bit more liquid assets. It was interesting for the IC to live through a scenario rather than just be presented with the outcome, and it showed how they might behave differently.”

As a result of the exercise the fund has made a slight tweak and allocated a bit more into traditional fixed income. “We found in that exercise what habits the IC would form and how we could make sure we are a position to give them options they wanted in that scenario,” Rule said. “There was a tendency for them to say we want to be able to change our mind, so liquidity is important.”

Liquidity management is as much a discipline as picking stocks or managing a credit portfolio and should be given more priority within pension funds

DAA as a tool for portfolio resilience

The role of active management, and in particular dynamic asset allocation, was also on the table, with participants acknowledging that downside protection can afford a fund a bit more “budget to focus on scenarios”.

Investors at the roundtable, including CPP Investments and Barclays, focus on long term strategic asset allocation but also think about dynamic asset allocation in the context of where exposures might be impacted by negative shocks and what hedges can be put in place.

Investors were perplexed by the energy transition and whether intermediate or long-term asset allocation better deals with the disruption. Other investors such as LPPI continue to have conversations around tactical tilts, but rarely act.

“On the occasions we have done it we try to be pro-cyclical, so try to think that we have liquidity, dry powder and can take advantage,” Rule said. “We haven’t found any managers who are good at timing markets, and we know we are not. My view is that we can exert a lot of time and effort into thinking about how we can be smart, but it hasn’t really paid dividends from doing that.”

Meanwhile, Church Commissioners built a big capability for dynamic asset allocation in-house in 2018. Joy said first-line defence – things like puts and foreign exchange – is done in-house for efficient portfolio management; then a second-line defence – which is tail risk hedging – has been developed with some banks.

“The main reason we developed it inhouse is to be time-variant and counter-cyclical. We only use it when we feel really stretched and want to add defence to the portfolio,” Joy said. “It was an enormous journey to get our trustees comfortable with putting the effort into basically building a derivatives capability inhouse. It became live in 2020 and the first thing we actually did was add risk because it was the summer of 2020. But we used it a lot last year and it proved very valuable and will continue with it. The biggest change has been on the internal operation capability.”

The UK’s largest private pension fund, USS has made ground on its path to net zero with effective engagement, measuring the Scope 3 emissions of its corporate assets and bottom-up carbon analysis focused on transition risk in emerging market equities. But investors need policy makers to do much more.

In the last year, the £75.5 billion Universities Superannuation Scheme, the United Kingdom’s largest private pension fund, has invested around £2 billion in renewable energy and clean technologies. The fund now also measures Scope 3 emission for around half of the companies in its portfolio despite poor availability and reliability of Scope 3 data. In another sign of progress, the fund is developing more informative climate scenarios with the University of Exeter in the hunt for insight into how investments might perform under a range of potential climate outcomes.

All steps that have helped USS reduce its carbon emissions intensity by 21 per cent since 2019 says the investor in its latest 2023 Taskforce for Climate-related Financial Disclosures (TCFD) Report, the industry-led framework that helps investors and companies understand and disclose their financial exposure to climate risk.

Engagement pays off

Engagement has been another centrepiece to strategy over the last year. For example, USS says engagement with Cemex, one of the world’s largest cement companies and one of the highest carbon emitters in its portfolio, contributed to the company setting more ambitious carbon reduction targets.

“Cemex is now set to reach its 2030 decarbonisation target five years earlier than planned and has introduced new lower-carbon concrete products,” says Innes McKeand, head of strategic equities at USS. “Higher-emitting companies can have the greatest real-world impact by shifting their ‘business as usual’ models to ones that drive change and push for a lower-carbon future.”

USS has also updated its policies. An updated Stewardship and Voting Policy states its preparedness to vote against the reappointment of directors if it believes a company is failing to appropriately manage or address a climate issue.

“We would expect to do this where, among other things, a company has not disclosed its climate transition plan or when a company is backtracking on previous climate commitments.”

Time for policy makers to do more

USS has built a £500 million sustainable growth mandate that includes investments in electric-powered aviation and carbon capture. The mandate targets high growth, privately-owned businesses that are developing services to help economies decarbonise.

However, McKeand flags the challenges of accessing these kinds of investments.

“We’re always looking for opportunities to increase our investments in climate solutions, but there are limited opportunities out there,” he says, arguing that the problem lies with an uncertain policy environment. “The Government and regulators have a huge part to play here, not least by ensuring a predictable, transparent, and stable regulatory environment for renewable energy assets and by raising energy efficiency standards.”

Managing asset level risk

USS has created Net Zero Working Groups (NZWGs) to drive progress whereby internal teams – the investor manages between 60-70 per cent of its assets in house – assess where reductions in carbon exposures can be made whilst achieving financial returns.

Recent initiatives include reducing emissions in the actively run global emerging markets (GEM) portfolio. Public equities represent approximately 30 per cent of assets and most of the allocation is managed passively against various indices. However, active management in the GEM portfolio includes engagement and voting, as well as identifying and integrating climate-related financial factors into investment decisions.

Here the team conducts bottom-up carbon analysis focused on transition risk to model how climate-related risks can impact the value of a company. The benefit of carbon analysis is that it can be integrated into existing discounted cash flow models, a tool used to value a business. This then feeds into an ESG score and assessment, along with other factors such as emission reduction plans and carbon transition.

Approximately 35 per cent of USS’s assets are managed externally and the firm’s net zero ambitions apply to all its assets, irrespective of asset class and whether those assets are managed internally or externally. In 2022, USS added to its monitoring processes by introducing a set of Gateway RI Indicators for manager selection teams to consider early in the shortlisting and manager due diligence process.

Next Steps

Looking ahead, USS will strengthen its top-down macro analysis by further integrating climate pathways with other macro factors. Elsewhere the investment team will continue to model different climate scenarios and mitigate some transition risks by moving away from standard equity benchmarks. For example, it recently applied a climate tilt to over £5 billion of the developed equities portfolio.

 

Pension fund in many emerging markets are under pressure because policymakers continue to allow savers to withdraw their money ahead of retirement. Juan Pablo Noziglia, CIO at Prima AFP in Peru explains the impact on one of the country’s largest funds as assets  fall by half due to early withdrawals.

In the last couple of years, Peru’s second largest pension fund, Prima AFP, one of four privately run defined contribution funds that people can choose over a state-run defined benefit pension fund, has seen its assets under management slashed by almost half.

Before the pandemic, Prima AFP managed $18 billion but today this has fallen to around $9 billion, whittled away because policymakers have allowed beneficiaries to withdraw up to $5,000 a go in six different withdrawals through the pandemic and its aftermath.

“Over the last couple of years, we have lost 52 per cent of our assets due to laws allowing withdrawals,” says Juan Pablo Noziglia, chief investment officer at Prima AFP speaking to Top1000funds.com from the fund’s Lima headquarters. “It’s the equivalent to a run on the bank.”

Withdrawals sought to alleviate the emergency triggered by COVID, but subsequent approval of beneficiaries tapping their pension for funds a fourth, fifth and sixth time are in stark contrast to pre-pandemic policies. Before COVID the only way beneficiaries could access their savings was after they turned 55 as monthly benefit, or at the end of their working life when they are permitted to withdraw the bulk of their savings to use as they see fit.

Prima AFP’s story reveals how the impact of the pandemic and subsequent cost of living crisis on pensions systems in developing countries is starting to unravel. FitchRatings estimates Peruvians withdrew 8 per cent of GDP from their pensions in 2021, while in neighbouring Chile, although a fourth withdrawal proposal failed in April 2022, savers withdrew about $50 billion (16 per cent of 2021 GDP) between 2020-2021.

It’s a similar story in other emerging economies like South Africa where pension funds like the R2.3 trillion ($0.12 trillion) Government Employees’ Pension Fund, GEPF, and the  R190 billion ($10 billion) Eskom Pension and Provident Fund (EPPF) wait to hear if the government will allow cash-strapped beneficiaries to drawdown their savings ahead of retirement.

In Peru, any halt on future withdrawals hangs on a decision from congress. A new cohort of policy makers responsible for shaping laws in the economic and budget commission are in the process of taking up office after which they will rule on submitted reforms to the pension system.

In the meantime, the future of pension funds like Prima AFP hangs in the balance, in marked contrast to Peru’s public pension fund which has not experienced any withdrawals.

“The public fund Oficina Nacional de Pensiones, ONP, has had zero withdrawals,” says Noziglia. “Because it is a defined benefit fund and a common pool, ONP can’t tell people how much they have saved and how much they can withdraw.”

the investment impact

Prima AFP offers beneficiaries four different asset allocations with different levels of risk, but mass withdrawals have had a dramatic impact on the pension fund’s ability to invest long term and diversify. Prima AFP used to comfortably lock up money in alternatives for ten years or longer, most of which was invested overseas in line with the fund’s ability to invest 50 per cent of assets abroad.

As withdrawals have gathered pace, Noziglia has had to change the allocation, selling down illiquid investments in buyout funds, secondaries and funds of funds and changing the portfolio construction. “As the withdrawals have come in, we have sold what we can rather than what we want.”

The problem lies in domestic liquidity constraints. The central bank has certainly tried to help. It has put in place measures to safeguard the local fixed income market by allowing pension funds to repo sovereign bonds (offering loans to pension funds guaranteed with sovereign bonds) thereby extending the time investors have to sell and are not forced sellers. Noziglia estimates the Peruvian bond market trades around $300 million a day, enough to allow investors “to move around” but at risk of crashing if Peru’s four DC pension funds on the hunt for liqudity all sold bonds on the same day.

As for the local equity market, although it has grown more liquid over time it only trades between $4-7 million a day. “One per cent of our fund accounts for around $90 million. I can’t go and sell the local market,” he says. In short, although he sells a patchwork of assets locally with the help of the central bank where he can, the bulk of the required liquidity has and will come from holdings outside Peru.

He’s just finished laying the groundwork in preparation for another liquidity call. This has involved working with specialist counterparties that allow the pension fund to be in a position to sell a large chunk of alternatives in secondary transactions if needed. “We are not keen on selling now, but if we have to, the door is open.”

In another, longer-term strategy, he is working with peers to educate people on the importance of Peru’s pension system but describes an uphill battle.

“Most people think we are pushing pensions because it gives us money,” he laments. “For the country as a whole, it makes no sense for people to reach the end of their working lives and retire with nothing in their accounts.” Although he’s encouraged by Peru’s healthier macro-economic picture, forecast growth and falling unemployment, he says the informal economy still dominates and getting people into the work place remains tough.

Peru’s ailing pension system is also having a knock on effect on the asset management sector where home grown firms are few and far between. Although local private debt managers are present, he says buyout and private equity asset managers as a whole are dying a slow and painful death compared to how the sector stood a decade ago. One of the problems is that although local companies may look “great on paper” unless they are regional champions, they struggle to attract buyers when they come to be sold.

“A lot of the problems in Peru are because of political instability,” he concludes.

Key Takeaways

  • For most of the past decade, the hedge fund industry faced headwinds to generate alpha as subdued volatility led to fewer trading opportunities and a near-zero interest rate environment hindered the process of asset price discovery.
  • Hedge fund industry performance displays a strong positive relationship between higher inflation and higher interest rate regimes. There are both structural and environmental reasons for the performance pattern of hedge funds in a higher inflation and higher interest rate environment.
  • The new and evolving macroeconomic environment plays to the advantage of most hedge fund strategies, and we expect it will lead to materially greater expected returns with similar—and potentially lower—levels of risk over the medium term.

In mid-2022, few outside the artificial intelligence (AI) community had heard of a chatbot called ChatGPT. However, by January 2023—only two months after its November 2022 release by OpenAI—ChatGPT was estimated to have reached 100 million monthly active users, making it the fastest-growing consumer application in history.1 This set off a proverbial AI gold rush; application developers, venture capital-backed startups, and some of the world’s largest corporations are all now scrambling to assess the possibilities of a world heavily influenced by generative AI tools.2

While many hedge fund managers are also incorporating AI into their processes, many are more focused on capitalizing on what is widely viewed as a new and more volatile market regime. As of July 2023, the US Federal Reserve had raised the Federal Funds Rate at 11 out of the last 12 meetings—including four straight 0.75% hikes—marking the fastest and most aggressive pace of rate increases since the early 1980s.3  With the Fed Funds rate jumping roughly 500bps in only 16 months (March 2022 – July 2023), hedge fund managers may also be experiencing a similar strategy-altering evolution of the economic environment.

The new and evolving macroeconomic environment plays to the advantage of most hedge fund strategies, and we expect it will lead to materially greater expected returns with similar—and potentially lower—levels of risk over the medium term.

A Market Environment of Higher Volatility

Following the Global Financial Crisis (GFC) of 2008-2009, both low inflation and meagre economic growth led to dovish global monetary policies and generous fiscal policies. As a result of easy money and ultra-low interest rates, volatility was dampened in most asset classes. Since early 2022, there has been a material increase in inflation that has led to a mostly coordinated attempt by central banks to remove market liquidity and raise interest rates, which has had the expected effect of increasing volatility in most asset classes. While rates and volatility are certainly higher now than in the decade following the GFC, they are reasonable when measured against longer timeframes. Furthermore, despite many economists and market participants believing that the shift to tightening monetary and fiscal policy may ultimately lead to recession, the jobs markets and risk asset performance to date have remained strong. However, despite debate around if and when the economy will have a soft landing or recession, there appears to be market consensus for a prolonged period of elevated macro volatility.4

For most of the past decade, the hedge fund industry faced headwinds to generate alpha as subdued volatility led to fewer trading opportunities and a near-zero interest rate environment hindered the asset price discovery process. Following the tightening of monetary policies, we now have a new macro regime characterized by greater volatility—which should also lead to better investing opportunities for hedge funds. Historically, when equity and fixed income volatility has increased, hedge fund alpha generation has also improved; this scenario occurred  as recently as the second half of 2022.

In the mid-2000s, hedge fund alpha generation was about 5%—similar to the average Fed Funds Rate during the period. Hedge fund alpha remained strong during the depths of the GFC and the period immediately following; nimble, opportunistic investors were able to find profitable trades in dislocated markets around the globe. It was the long subsequent period of low rates and low volatility that caused and supported an environment in which there was little economic uncertainty, resulting in low dispersion within asset classes from which hedged investors could profit. There are few ways for hedge fund strategies to generate alpha when all securities trade in sync, equity and bond markets trend based on monetary policy, and volatility remains low.

Historically, the hedge fund industry has displayed a strong positive relationship between higher inflation and higher interest rate regimes and better hedge fund performance.5 In periods marked by low inflation,6 hedge funds have generated absolute returns that are approximately half (52%) of those available to equity investors; in periods of high inflation,7 hedge funds have materially exceeded US equity market returns. When inflation has been close to the Fed’s long term target of 2%, we see that hedge fund returns were roughly in-line with equities; however, hedge funds have generated these returns with significantly lower volatility due to the relative value orientation of many hedge fund strategies, resulting in a Sharpe ratio greater than 1.0, as illustrated in the chart below.

How Hedge Funds May Benefit from Higher Volatility

There are both structural and environmental reasons for the performance pattern of hedge funds in a higher inflation and higher interest rate environment. From a structural perspective, many hedge fund strategies maintain high levels of unencumbered cash. Managers typically seek leverage by using financial derivatives that have low margin requirements. Hedge fund strategies such as trend following, global macro, and fixed income relative value (among other strategies), often have cash levels in excess of 50% of the funds’ net asset values. As a result, when short-term cash instruments (e.g., money market funds, short term T-bills etc.) offer materially higher interest rates, it creates a total return tailwind for these investment managers. Additionally, equity long/short managers benefit from the increased interest on the proceeds from shorting stocks (i.e., short rebate). For example, a market neutral hedged equity manager running a 100% long and 100% short portfolio is now able to harvest an annualized positive carry of approximately 5%, compared to near 0% in the prior decade.8

Interest rate normalization increases the value add of security selection. Over the last decade, we observed a one-way multiple expansion as the S&P 500 price-to-earnings multiple doubled from 11x to 22x from 2010 to 2021. In this environment, alpha generation from security selection was difficult as stocks all rose together. In our current higher rate environment, we have already seen contraction in price-to-earnings multiples, which will increase the importance of security selection.The evolving market backdrop has increased the opportunity set not only for equity strategies, but also for credit managers. With liquidity being removed from markets and companies refinancing into a higher interest rate environment, corporate defaults are already on the rise. We expect this increase to continue as more companies’ bonds mature and some firms are unable to refinance at the new, higher rates on offer.

Finally, the new macroeconomic regime has been a significant tailwind in the trading environment for tactical trading managers. Trend following and directional macro managers benefited from the coordinated rise in interest rates during 2022 to post one of their strongest return years on record due to the performance of the fixed income portions of their portfolios (for reference, for calendar year 2022, HFRI Macro Index returned 8.8% and SG CTA Index returned 20.15% vs MSCI World -18.5% and Barclays Agg -13%).9 Fixed income relative value managers were able to profit not just from the higher level of interest rates, but also from the increased volatility in fixed income markets allowing them to meet their return objectives at lower levels of leverage and risk. We expect the environment to remain attractive for tactical trading funds in the medium term, particularly for global macro managers who may be able to profit from divergence in the monetary and fiscal policies of both developed and emerging economies as inflation normalizes in certain countries while remaining high and problematic in others.

Manager Selection in a Higher Volatility Environment

While a higher volatility market backdrop may benefit a number of hedge strategy types, selecting high-quality hedge fund managers remains the most critical feature of a successful hedge fund program. Unlike traditional long-only equity and fixed-income fund managers who typically risk manage their tracking error versus a benchmark, hedge fund managers are mostly absolute return focused and benchmark agnostic. If one were to place investment managers on a passive-to-active spectrum, hedge fund managers sit on the most active side of the spectrum. As a result, the performance dispersion amongst hedge fund strategies, even across those running similar strategies, is widely distributed.

When looking at our hedge fund database since 2008, which is comprised of more than 8,000 hedge fund strategies, we found a persistent dispersion of greater than 10% return between the 25th percentile and 75th percentile hedge fund managers. This dispersion increased during more volatile market environments (i.e., 2008, 2009, 2020, and 2022), averaging an annual return dispersion of over 20%, as shown in the chart below. Interestingly, when analyzing the sub-strategy level performance on a beta-adjusted basis (e.g., a measure of the skill-based return, or alpha of managers), the Information Ratio dispersion is notably wide across strategies and across various time horizons.

To identify high-quality managers, a robust manager selection and comprehensive diligence process is required. Hedge fund strategies are more complex than traditional long-only equity and fixed income managers. Relative to traditional investment strategies, hedge fund managers will utilize higher balance sheet leverage, make extensive use of derivatives and complex trade structures, add illiquid investments, and typically have more frequent trading tendencies. Hedge fund businesses can also be challenging to assess. Hedge fund managers are generally smaller and less diversified than established traditional asset managers—which introduces an elevated level of organizational risk.

In addition to the challenges of underwriting managers, turnover is high in the hedge fund industry. New fund launches and fund closures amongst a universe of >8,000 hedge funds present a dizzying array of options for investors to track. Based on our analysis, we estimate that on average since 2009, more than 10% of hedge fund strategies exited the industry each year. We estimate new entrants to be approximately 10% per year on average as well representing total industry turnover of approximately 20% in any given year.10

While underwriting a strategy and assessing the ever-changing hedge fund universe may be difficult, the ability to identify skill can help to compound returns over time. We have historically observed that skill may adapt, and skill may persist. For example, using risk-adjusted returns as a proxy for skill, a manager that achieves a top quartile Sharpe Ratio ranking in one year is likely to be above the median manager the following year as well, as shown in the chart below. Although it is ill-suited to evaluate a hedge fund based on a single year’s performance, it is notable that this persistence of skill is consistent across strategy types, with credit long/short and quant macro the lone exceptions. In the world of hedge fund investing, we believe the persistence of skill translates to alpha. And alpha translates to returns that are diversifying and can meaningfully enhance the risk-adjusted returns of an overall portfolio.

The Only Constant is Change

The adaptability of hedge fund managers is key to survival given the Darwinian nature of financial markets. In fact, adaptability is one of four key criteria we assess when evaluating managers.11 We like to think of a down escalator as a metaphor for the continually changing and highly competitive investment landscape for a skill-based manager: if the manager is standing still on the escalator and not continuously adapting, the manager will likely be taken down. A manager that can successfully adapt is not only able to keep pace with the escalator, but also stays one step ahead. Like the technology companies now seeking to capitalize on the promise of generative AI to upend traditional processes, skill-based managers are also adapting to a new and more volatile market regime.

Important Information

1 Reuters, “ChatGPT sets record for fastest-growing user base – analyst note.” As of February 2, 2023.

 

2 MIT Technology Review, “ChatGPT is about to revolutionize the economy. We need to decide what that looks like.” As of March 25, 2023. 

 

3 World Economic Forum, “The pace of US interest rate hikes is faster than at any time in recent history. Is this creating a risk of recession?” As of October 12, 2022

 

4 Goldman Sachs Global Investment Research, “First to the Finish: Early Hikers and the Rate Cut Outlook.” As of July 27, 2023.

 

5 Bureau of Labor Statistics, Bloomberg, HFRI. Analysis from 1990-2022.

 

6 Defined as inflation less than 2%.

 

7 Defined as inflation greater than 4%.

 

8 Goldman Sachs Prime Services, Prime Insights, May 2023.

 

9  MSCI, See additional disclosures.

 

10 Goldman Sachs Asset Management XIG Hedge Fund Database. As of 2022.

 

11 The other three criteria as part of the XIG process are Governance, Infrastructure, and Process.

 

 

 

Glossary

 

Alpha refers to returns in excess of the benchmark return.

 

Carry is the return obtained by holding an investment for a given period.

 

Price-to-earnings multiple is the ratio of an asset’s price to earnings.

 

Price-to-equity is the ratio of the price per share to the book value per share.

 

S&P 500 index is the Standard & Poor’s 500 Composite Stock Prices Index of 500 stocks, an unmanaged index of common stock prices.

 

Risk Considerations

 

All investing involves risk, including loss of principal. 

 

Alternative investments are suitable only for sophisticated investors for whom such investments do not constitute a complete investment program and who fully understand and are willing to assume the risks involved in Alternative Investments. Alternative Investments by their nature, involve a substantial degree of risk, including the risk of total loss of an investor’s capital. 

 

Alternative Investments often engage in leverage and other investment practices that are extremely speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the loss of the entire amount that is invested. There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. Similarly, interests in an Alternative Investment are highly illiquid and generally are not transferable without the consent of the sponsor, and applicable securities and tax laws will limit transfers.

 

Investors should also consider some of the potential risks of alternative investments:

 

·  Alternative Strategies. Alternative strategies often engage in leverage and other investment practices that are speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the entire amount that is invested.

 

·  Manager experience. Manager risk includes those that exist within a manager’s organization, investment process or supporting systems and infrastructure. There is also a potential for fund-level risks that arise from the way in which a manager constructs and manages the fund.

 

·  Leverage. Leverage increases a fund’s sensitivity to market movements. Funds that use leverage can be expected to be more “volatile” than other funds that do not use leverage. This means if the investments a fund buys decrease in market value, the value of the fund’s shares will decrease by even more.

 

·  Counter-party risk. Alternative strategies often make significant use of over- the- counter (OTC) derivatives and therefore are subject to the risk that counter-parties will not perform their obligations under such contracts. 

 

·  Liquidity risk. Alternatives strategies may make investments that are illiquid or that may become less liquid in response to market developments. At times, a fund may be unable to sell certain of its illiquid investments without a substantial drop in price, if at all. 

 

·  Valuation risk. There is risk that the values used by alternative strategies to price investments may be different from those used by other investors to price the same investments. 

 

Alternative Investments – Hedge funds and other private investment funds (collectively, “Alternative Investments”) are subject to less regulation than other types of pooled investment vehicles such as mutual funds. Alternative Investments may impose significant fees, including incentive fees that are based upon a percentage of the realized and unrealized gains and an individual’s net returns may differ significantly from actual returns. Such fees may offset all or a significant portion of such Alternative Investment’s trading profits. Alternative Investments are not required to provide periodic pricing or valuation information. Investors may have limited rights with respect to their investments, including limited voting rights and participation in the management of such Alternative Investments.

 

The above are not an exhaustive list of potential risks. There may be additional risks that are not currently foreseen or considered.

 

Conflicts of Interest
There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. These activities and interests include potential multiple advisory, transactional and other interests in securities and instruments that may be purchased or sold by the Alternative Investment. These are considerations of which investors should be aware and additional information relating to these conflicts is set forth in the offering materials for the Alternative Investment.

 

General Disclosures

 

This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.

 

THIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORIZED OR UNLAWFUL TO DO SO.

 

Prospective investors should inform themselves as to any applicable legal requirements and taxation and exchange control regulations in the countries of their citizenship, residence or domicile which might be relevant.

 

Economic and market forecasts presented herein reflect a series of assumptions and judgments as of the date of this presentation and are subject to change without notice.  These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client.  Actual data will vary and may not be reflected here.  These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes.  These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Goldman Sachs has no obligation to provide updates or changes to these forecasts.  Case studies and examples are for illustrative purposes only.

 

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Examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially.

 

Neither MSCI nor any other party involved in or related to compiling, computing, or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability, or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent.

 

Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur.

 

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Key Takeaways

  • We believe generative artificial intelligence (GAI) has the potential to significantly alter both the economic and investment landscape—making it more than just hype.
  • In our view, companies with the infrastructure to integrate AI with their existing platforms and businesses building crucial generative AI components appear well-positioned for early success.
  • Despite risks ranging from misinformation to labor displacement, we believe that widespread adoption of generative AI could provide immense long-term benefits to society.

The idea behind machines being able to think like humans has been around for nearly a century. In the 1940s and 1950s, computer scientist Alan Turing wrote a paper on machines being able to simulate human beings and created the world’s first “Chess-bot.” The term “artificial intelligence” was first used in 1956 by Stanford Professor John McCarthy, who later defined AI as “the science and engineering of making intelligent machines, especially intelligent computer programs.”1 To be sure, machine learning and artificial intelligence are not new concepts in investing, and in fact, both have been used in quant strategies for some time.

The renewed excitement around the topic stems from the generative aspect of AI. In November 2022, OpenAI released the first generative artificial intelligence (GAI) chatbot, ChatGPT. Put very simply, ChatGPT is a computer program designed to simulate conversation with human users. It can tell you a joke. It can report on the weather. It can even write this whitepaper. By using generative AI vs. traditional AI, ChatGPT can not only “hold a conversation” much better than chatbots of yesteryear, but also can translate language to code, write a resume for an entirely fabricated position, or create song lyrics about your favorite holiday in the writing style of Edgar Allen Poe. ChatGPT’s popularity soared, and within 5 days of being released, the software had over one million users. Furthermore, it was one the fastest applications to reach 100mn users ever.

HOW DOES IT WORK?

GAI’s functionality can be attributed to three key components: 1) neural networks, 2) deep learning, and 3) natural language processing (NLP). Just like human brains, GAI works on a system of multiple neural nodes that process and filter through information in multiple states. Consider a program that is teaching a computer to recognize paintings, and we show this program Andy Warhol’s Campbell’s Soup Cans.2 The initial layer in this artificial neural network is like the optic nerve, feeding raw data from the “eyes” to the “brain.” Data then flows through several neurons, and each has a different function and can communicate with others; perhaps the first is searching for edges and passing information along to the second, which is searching for shapes and passing information along to the third, which is searching for specific features. In this example, each node is an individual knowledge hub that screens and classifies data at each stage, ultimately leading to the model identifying the correct work of art. Taking the analogy one step further, deep learning is a means of machine learning through unstructured data.

Traditional machine learning may have required humans to tell the program specifically what to look for—if a painting contains pop art, the artist may be Andy Warhol or Keith Haring. By showing the program thousands of depictions of pop art, it can draw its own conclusions and further improve its analytic capabilities. Finally, NLP enables computers to interpret speech, gauge interest, read text, and evaluate images, both with syntactic and semantic analysis. By using NLP, a GAI model that is shown Campbell’s Soup Cans may be able to posit conclusions on the meaning behind the painting: perhaps Warhol depicted what he did to show that art should be for everyone, not just cultured curators, or maybe he was just an avid soup consumer! Put very simply, neural networks, deep learning, and NLP are all means of how AI thinks.

Is GAI Just Another Hype Cycle? 

One of the key points of skepticism around investing in artificial intelligence is the debate as to whether it is another bubble. We argue that it is not, because AI is already making an important impact in investing, and because funding for GAI has already surpassed that of previous hype cycles at their respective peaks. Artificial intelligence and machine learning have been used in quantitative investment strategies for several years. Anyone who has ever used a trading algorithm has likely taken advantage of AI in investing, as many of these algorithms are making decisions based on large data sets at high speeds or exploiting possible arbitrage opportunities. AI can also be used to optimize asset allocations to construct portfolios that might perform better than those constructed with traditional techniques, aid in pre- and post-trade analysis, and analyze market and credit risk. While less known, some large language models may also be used in both sentiment analysis—e.g., comprehending subtext of corporate earnings calls—and portfolio optimization. Most recently, a GAI model was created to analyze Federal Reserve statements and assign them a “Hawk-Dove score,” with the goal of detecting potential trading signals.3 We expect these links between AI and investing to become even more intertwined as society becomes more familiar with the technology.

 

“Something else that sets GAI apart from many prior technological advancements is its potentially drastic impact on economies.”

 

Another indication that AI may persist for some time is the amount of funding that is being deployed. In the first quarter of 2023, GAI companies raised $2.3bn from venture capital firms. Quarterly VC fundraising for the metaverse at its peak in 2021 was only $2.1bn. Large corporations are taking a similar interest; in 4Q 2022, there were only 10 mentions of “generative artificial intelligence” on S&P 500 company correspondences. We believe this stemmed from Microsoft’s purchase of a $10bn stake in OpenAI. In 2Q 2023, this number increased drastically, and even Mark Zuckerberg, who changed the name of his company to Meta in 2021, said, “[Meta’s] single largest investment is in advancing AI.”

Of course, using AI also includes challenges. For instance, increasingly opaque algorithms can make it difficult for humans to monitor, evaluate, and understand how AI models will respond to inputs, anomalous events, or complex tasks. Additionally, AI relies on large amounts of data, especially in the learning phase. The quality and availability of this data can lead to improper calibration, skewing results.

We recognize that there may be growing pains with AI and acknowledge the potential risk of markets getting ahead of themselves. But in our view, GAI is here to stay.

Economic Impact of GAI

Something else that sets GAI apart from many prior technological advancements is its potentially drastic impact on economies. In the long term, we believe that widespread adoption of GAI has the potential to materially change our lives, interactions, and all of human existence. Goldman Sachs Global Investment Research economists have likened the impact of GAI to two milestone inventions in human history: the electric motor in 1890 and the personal computer in 1981. In each of these instances, the productivity “boom” did not begin until roughly 50% of businesses adopted the technology—a threshold that took 20 years to reach. After reaching this threshold, however, labor productivity grew by 1.5 percentage points annually for over a decade, and we believe that widespread adoption of GAI could yield similar effects to the tune of a 7% annual increase in global GDP, which stems from two main channels. First, many workers are employed in occupations that are partially exposed to AI automation. If AI can increase workers’ capacities, then plausibly, said workers may direct some of their newfound time toward more productive activities. Second, if workers do end up being displaced by AI automation, we believe that these workers will eventually become reemployed, and therefore boost total output. The size of GAI’s impact will ultimately depend on its true capabilities and adoption timeline, but we believe that it is possible to begin reaping the economic benefits of GAI sometime in the latter years of the 2020s.

Technological Impacts of GAI

AI has seemingly been the darling topic on company calls across industries. As of the end of June, the phrase was mentioned 3,330 times according to Bloomberg.4 The surprising aspect of this viral growth, aside from the broad volume of mentions, has been the range of companies—from Microsoft to Kraft to Moderna to Zoom—that are trying to incorporate AI into their businesses. As previously mentioned, the most widespread use of GAI thus far has been chatbots. Following Microsoft’s substantial investment in OpenAI for the use of ChatGPT, other tech companies have increased efforts in making their own chatbots (Google’s Bard, Snapchat’s “AI”). The functionality of chatbots extends far beyond jokes and weather updates. Chatbots have the potential to revolutionize customer service and improve the efficiency of human searches/research—ask ChatGPT to plan a travel itinerary of a camping trip for proof. Additionally, chatbots are becoming smarter and more sophisticated at incredible rates. Chatbots are not the only notable application of GAI. Through NLP, AI is being used to help programmers write original code. In some instances, according to Goldman Sachs Chief Information Officer Marco Argenti, developers are accepting nearly 40% of code written by AI,5 which could boost programming productivity by double digit percentages. Eventually, AI will be used in entertainment, medicine, and nearly every industry.

Investment Impact of GAI

Outside of the question, “is AI going to take over humanity,” investors are most curious as to where they can strategically position their portfolios to take advantage of its new developments. Given the different components of the GAI tech stack—including apps, hardware, cloud platforms, foundation models, and model hubs—companies may want to consider tech investments to capitalize on the benefits of GAI.

 

“There seems to be a plausible case for gai in just about every industry.”

 

In our view, the groups who may prosper the most are 1) large companies with infrastructure who can integrate AI with their existing platforms, 2) companies that produce both the components of AI and build/license GAI models, and 3) companies outside of technology who are most willing to scale their own AI adoption. Unsurprisingly perhaps, large tech companies with strong infrastructure stand to gain from the advent of new tech. By implementing AI models into existing productivity tools, workers could benefit from increased efficiency and the ability to leverage multiple sources of data in one application. For example, someone creating a presentation could use GAI to pull notes from a text document and populate a slide in a slideshow, all without leaving the slideshow application. Furthermore, GAI can help employees who are not as well-versed in software to take full advantage of the tools available to them.

Outside of just productivity, tech companies may be positioned to quickly adopt GAI in search engines—DevOps and cybersecurity to name a few. Second, there is now a global demand for GAI models, but not all companies have the infrastructure/resources to build their own. For a smaller company looking to increase productivity, it makes sense to subscribe to use an AI model that was created externally. We also believe manufacturers of graphics processing units (GPUs) and other components of AI may be able to succeed. Finally, given that roughly 66% of jobs are exposed to AI automation, we believe that any company that can embrace GAI to improve its efficiency could benefit. Healthcare is just one example of a sector in which GAI tools could be leveraged for patient diagnosis, personalized treatment plans, and novel drug design. There seems to be a plausible case for GAI in just about every industry, and although there are very few jobs in which GAI can automate more than half the work, we believe widespread adoption of GAI could provide a double-digit productivity boost in many fields.

Despite being in the early stages of discovery and adoption, the potential advantages of GAI are hard to ignore. However, the narrowness of the recent market rally may be evidence that the markets may not have fully embraced AI yet. Because it is unclear how exactly the adoption of GAI will impact company fundamentals, it may be too early to tell if GAI companies are overvalued, and it is unclear if traditional valuation methods should be applied in this space. Having said that, some tech valuations are severely stretched. Investors may have difficulty in selecting future GAI winners at the right price. As managers continue to study the space, the markets may dictate new valuation dynamics, potentially with the help of AI.

 

Key Risks

We see three main risks when it comes to widespread adoption of AI technology: 1) privacy and copyright issues, 2) ethical issues, and 3) labor displacement. The large language learning models upon which AI platforms are built leverage huge amounts of data to train, meaning that a cyber-attack or data breach could potentially cause significant damage. More unique to GAI is the risk of copyright infringement. While still early, notable examples of AI “theft” have come from the music industry, in which sound engineers have been able to use artificial intelligence to create original music with AI versions of famous artists’ voices. In some instances, the replication is uncanny. There is also the matter of ethical issues when it comes to using AI, notably in the forms of plagiarism and misinformation. As mentioned earlier, GAI models are trained on existing available data, so the likelihood of content being plagiarized is higher, and it is the user’s responsibility to sensibly use the content generated. Additionally, GAI tools have been under scrutiny around the accuracy of information being disseminated, which can be dangerous to users like asset managers who are unable to verify them.

Despite the dangerous risk that misinformation poses, the risk that we feel is most impactful is labor displacement. We believe that approximately two-thirds of US occupations are exposed to some degree of AI automation, with particularly high exposures in administrative and legal professions but low exposures in construction and maintenance. An estimated 7% of jobs could be displaced.6 However, history shows that worker displacement from automation is mostly offset by the creation of new jobs. Sixty percent of the jobs that exist today did not exist in 1940, and over the last 80 years, the technology-driven creation of new jobs has accounted for 85% of employment growth.7 We expect AI to be no different, with new roles being created in data science, AI research, and engineering, to name a few. Additionally, while the future interplay between labor unions and GAI is unclear, we have already seen that unions in industries like airlines, medicine, and entertainment writers are navigating the nuances of emphasizing human involvement in jobs while seeking protections from companies and government regulations against being replaced completely.

We feel that GAI could drastically change both the economic landscape and the investment landscape. As with many new technologies, there are certainly risks, but we believe that the benefits of adoption of GAI far outweigh the costs. Through GAI, humans are given some of the most futuristic “game pieces” the world has ever seen with no gameboard or instructions on how the game should be played. That is where the art and imagination of artificial intelligence takes hold. As civilization starts to learn how to wield these tools, we believe the possibilities for innovation could be truly endless.

Important Information

1 John McCarthy, “What is Artificial Intelligence?” As of November 12, 2007.

 

2 Museum of Modern Art, Andy Warhol’s Campbell’s Soup Cans, 1962.

 

3 Bloomberg, “JPMorgan Creates AI Model to Analyze 25 Years of Fed Speeches.” As of April 26, 2023.

 

4 Bloomberg and Goldman Sachs Asset Management. As of June 30, 2023.  

 

5 The Wall Street Journal, “Goldman Sachs CIO Tests Generative AI.” As of May 2, 2023.

 

6 Goldman Sachs Global Investment Research, “The Potentially Large Effects of Artificial Intelligence on Economic Growth.” As of March 26, 2023.

 

7 Goldman Sachs Global Investment Research, “The Potentially Large Effects of Artificial Intelligence on Economic Growth.” As of March 26, 2023.

 

Glossary

 

Artificial intelligence is the development of computer systems able to perform tasks that normally require human intelligence.

 

Generative AI is a type of AI system capable of generating text, images, or other media in response to prompts using a database.

 

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