In the world of fintech and artificial intelligence (AI), do we still need hedge funds?


Seminar Paper, 2020

24 Pages, Grade: 1,3


Excerpt


Table of contents

1 Introduction

2 Definitions
2.1 What is Fintech?
2.2 What is artificial intelligence?
2.3 What are hedge funds?

3 The beginning of the fintech era
3.1 Changes in regulatory and economic space
3.2 Evolution of technologies in financial institutions
3.3 Changes in customer expectations

4 Implementing fintech
4.1 Static institutions and operations cost
4.2 Partnerships between established institutions and newcomers
4.3 Successful FinTech example

5 Artificial intelligence in financial services
5.1 What AI can do
5.2 AI and humans

6 Who invests in hedge funds?
6.1 Institutional investors
6.2 High net worth individuals

7 Why do people invest in hedge funds?
7.1 Niche opportunities and alternative investments
7.2 Portfolio diversification
7.3 Alpha generation

8 Conclusion

9 Literature

1 Introduction

“Well, I don't think that hedge funds are bad per se. I think they are just one more financial tool. And in that sense, they're useful” - Barack Obama (Williams, 2007)1

Today, customers want the best products and services combined with the best user experience and last but not least, they want options. In other words, they want it all and they want it now, and for the financial services industry it may be the biggest challenge in history.

New generations of customers with unlimited access to information are now informed about the new technologies, tools, and products in a matter of minutes, and they want to be a part of it.

A new breed of financial institutions called “Fintech” with a more technology-driven infrastructure are fulfilling the customers wants and needs, by taking advantage from new regulations created after the financial crisis of 2008, that made old traditional financial institutions expensive to operate and slower to innovate, gave these innovative, sometimes borderless fintech companies a competitive advantage.

Thanks to data and artificial intelligence (AI), customers have access to tailor-made financial products and services not only in banking but also in areas like investing and financial planning and advisory, in an inexpensive but efficient way, something that before was mostly available only for the rich and well-connected people. This made the financial industry in a way fairer and more transparent.

But there are still some financial entities like “hedge funds” that are still reserve only for the wealthy investor. These entities are famous due their unconventional ways to make money in the markets and bringing investors outstanding returns, beating the market.

On this paper we answer the question: In the world of FinTech and AI, do we need still hedge funds? We describe and analyze how these three subjects are connected and how they are changing the financial services ecosystem. Are fintech companies and AI enemies from hedge funds? Do these industries complement each other? We hope you are as excited as we are to investigate these subjects.

2 Definitions

2.1 What is Fintech?

Fintech surges from the combination of finance and technology. Fintech makes use of the availability of big data and the improvements of computers such as artificial intelligence. It enables firms to provide new financial and technological products and services that are not typical, but they are even more dynamic and cost effective than the ones that are currently offered by the financial institutions. The application of fintech is revolutionizing many industries, from payments to financing, asset management, insurance and advisory. One important thing to mention is that the solutions provided by fintech are very scalable which causes market disruption on a global scale.

Fintech solutions are not only provided by established institutions. Normally start-ups are the ones that disrupt the industry since big financial institutions often are too static and therefore slow in implementing new technologies. Big financial institutions have acquired a lot of startups in the past years trying to stay competitive and keep leading the market. (Dong He, Ross Leckow, etc. 2017)2

2.2 What is artificial intelligence?

Artificial intelligence is a program created by humans that learns by itself by solving different tasks. AI consists of two terms describing it as a smart program which can think by itself and is created by humans. Computers play an important role in the everyday lives since they work faster, more efficiently and they can memorize and analyze a lot more data than humans can ever think of. But a “normal” computer is just able to do things a programmer has taught it to do. In difference to this, AI “implements ´deep learning´ neural networks” (Das 2019, p. 985) 3 to analyze all the available data more efficiently to provide better solutions than non-AI computers and humans as it learns from previous tasks and thus improves its system constantly. (Das 2019)3

2.3 What are hedge funds?

A hedge fund is an investment partnership normally between the general partner of the fund who invests the money of the fund according to the funds strategy and the investors who provide the equity for the investments. As any other type of investment fund the goal is to provide to the investors the highest return of investment possible and eliminating risk or “hedging”.

There exist a multitude of types of hedge funds which are normally specialized in one area or type of investment. Usually a normal investor is not allowed to invest in these types of funds and only accredited investors can invest due to the high risk that comes along investing in hedge funds.

Additionally, hedge funds allow to invest in practically everything (land, stocks, natural resources, etc.) and use any kind of investment form or financial product to achieve the investors goals. Often, they use unconventional ways to invest that are not offer to the normal investor.

Similarly, to other funds general partners charge annual fees which depend on the size of the fund. But general partners also charge performance fees on profits which act as an incentive for the general partner to manage the fund well and increase returns. (Gad, 2013)4

3 The beginning of the fintech era

The decade after the world financial crisis in 2008 gave place to a lot of new players in the financial services industry. Those new companies were different to the normal financial institutions. New companies were more agile and Technology-focused that the other companies, and thanks to the customers lack trust in traditional financial institutions, people was open to try new ideas. Fintech companies started to disrupt the market and catching a lot of attention not only for customers but from investors too. Global fintech investment in 2019 with $135.7 billion across 2,693 deals (KPMG International)5. To understand better what is driving the revolution in the financial industry and why it is happening now we must think in the main topics which are:

- A changing regulatory economic and regulatory space
- Rapid evolution of technology
- Change in customer expectations

3.1 Changes in regulatory and economic space

After the financial crisis of 2008 financial institutions were punished with new economic regulations to prevent that a crisis of this magnitude happens again. That made the financial institutions very heavy to operate and it did not leave much space to innovation. That created a window of opportunity for fintech startups because they did not have to carry these regulatory and economic burdens and their flexibility and agility gave them the a lot of competitive advantages to exploit some of the regulatory windows and offer a new financial products and services.

In addition, around the same time new financial regulators were created like the Financial Conduct Authority (FCA) based in the United Kingdom that encouraged new non-traditional financial institutions to enter the market and created a new breed of financial services. These new regulators gave the startups the first “yes” that made possible to operate. Thanks to the positive reactions from customers and their will to try and change their traditional infrastructure to a more “modern” one made that other regulators around the world started to give new licenses to new ventures. (Arslanian and Fischer 2019)6

3.2 Evolution of technologies in financial institutions

The new technology focused startups started taking advantage from the new technological solutions implementing them in their products and services. Financial institutions after being sure that they complied all the new standards and regulations started investing heavily in new technologies, but the problem was that the institutions were so deep in systems that were out of date and the migration of data, plus they old school way of operating was just too difficult and the companies found themselves in a very rigid and uncompetitive position against new companies. (Arslanian and Fischer 2019)6

3.3 Changes in customer expectations

While some financial institutions recognized the potential of engaging with customers via new platforms like smartphones, leveraging cloud computing, or even exploring new trading strategies enabled by artificial intelligence (AI), actual implementation was extremely difficult within an operating model constrained by 40-year-old mainframe systems. (Arslanian and Fischer 2019, P. 28)6

For that reason, financial institutions started to acquire new talents focused to adapt and create new products and services that are more accordingly to customers and that leaded to a wave of awfully expensive acquisitions of startups to stay competitive. Customers want an all integrated experience that solves all their problems and wishes in touch of a button.

An incredibly good example is Apple Pay, the new Apple financial product American customers can have a credit card with just 6 clicks, no need for paperwork or log lines in the bank which makes the whole customer experience much better. We can see a clear tendency that all the financial services powered by big data can offer tailor made solutions to everyone of their clients which make the user feel important and understood by the financial institution.

Another important point is the number of users. Apple claims that they have 1.4 billion active devices which makes all the owners of the device potential customers or more common instant clients of every product that the company brings to the market. Why people want to become a user of these services? Because they trust the Apple ecosystem. That means that when a customer is happy with a technological infrastructure and ecosystem they try to operate only with services and products that are part of the ecosystem, this gives virtually every company that has big number of users the possibility to become a financial institution too. (Set up Apple Pay, 2020)7

A particularly good example is Razer. This company is a great example of the worth of every user and basically proves that every company that has many users can become a financial institution.

Razer is the world leading lifestyle brand for gamers. The company founded in 2005 by Min-Liang Tan is double headquartered in Singapore and the United States. Razer is currently the biggest gamer ecosystem in the world and provides all the products and services that gamers need. The company has over 80 million users around the world.

But Razer does not only sell computers and equipment it provides financial services too. Thanks to Razer Pay and the e-wallets, users can make transactions around the world. A database of 80 million around the world, who are fans of the brand and basically will buy everything that it offers is the key success of the company. Razer is a clear example of the power of data. (Razer Pay - Mobile Wallet App, 2020)8

4 Implementing fintech

Financial institutions often are big market participants which are responsible for the money that people are investing. But as there are thriving new technologies in the financial sector that can change the sector and improve investing, big financial institutions have not been the ones leading the way. Start-ups have been more successful implementing and developing those technologies.

4.1 Static institutions and operations cost

The problem with big financial institutions would be that they are not flexible enough to adapt to modern technologies. First, many institutions are using technology which has been in offices for more than 40 years which shows the stability of them but also limits the institution in their technological capabilities. In addition, half of banking systems and almost every ATM is based on an outdated program called COBOL.

The advantage for startups regarding the situation of financial institution is that they placed all their services in the cloud. This allows them to make changes in their programs more easily. Additionally, startups can save costs by automation. For example, face recognition software has proven to be a lot better than human recognition. While start-ups are using technology such like this, financial institutions are still relying on personal contact and people identifying themselves with their card. This is to some extent understandable, but by automating their processes, financial institutions can work more efficiently such as the upcoming start-ups.

The reason big financial institutions are not dominating the new technologies is not their spending. Global bank IT spending in 2018 increased to $216 million. But this expenditure is mostly used for maintenance of old systems and meeting new regulatory requirements. (Arslanian and Fischer 2019)6

Another important point is the cost that have big financial institutions versus fintech startups. A big financial institution like the Deutsche Bank has a cost per transaction of around 2 USD, but dynamic fintech startups like N26 thanks to cloud-base infrastructure and by not having a big operations cost, have a transaction cost from around 1 cent which gives N26 a big competitive advantage over Deutsche Bank. (Interview with Jorge Ruiz, Founder and CEO of FinConecta, 31st March 2020)9

4.2 Partnerships between established institutions and newcomers

Some financial institution had success in creating FinTech products for their customers. There are positive examples like JPMorgan´s COIN system or the development of a chatbot called Erica used by the Bank of America. But many big institutions tend to leave their plans to install in-house fintech services before they can reach their goals.

Many institutions are behind as they are treating fintech as something you cannot combine with traditional financial services. There often must be separate offices in order to implement new services. Additionally, most millennials who in general rather do not want to work for banks can be attracted with modern office space. Most importantly, management must assure its full support which is not always the case. “[More] than 82% of incumbent financial institutions expect to increase fintech partnerships in the next three to five years.” (Arslanian and Fischer 2019, p. 66)6 According to the PwC Global Fintech Report more institutions want to work with new fintech companies, due to the problems they have with fintech. Many big institutions have formed teams and spaces that focus on finding ways how to collaborate best with fintech ventures. The most common kinds of collaboration or acquiring important knowledge from fintech companies in order to be successful in the sector, is mergers and acquisitions and CVC funds.

While the number of deals in 2019 diminished, big financial institutions are more interested in matured fintech companies that bring new ideas and products into their company. That is why in 2019 there were more mega-deals like the acquisition of Worldpay for $42.5 billion which makes up almost half of the total M&A. (KPMG International; Arslanian and Fischer 2019)6

That is why companies have created platforms where financial institutions can meet new innovative fintech startups and find all type of technological solutions for their businesses. That is the case of a Miami-based company called FinConecta. The company created a platform called “4wrd” where finance and technology meet. FinConecta integrates financial institutions core banking systems with third party fintech companies from all around the world. Platforms like 4wrd accelerate innovation by making easier the integration of third-party solutions, enabling financial institutions to create their own ecosystem. (Interview with Jorge Ruiz, CEO, and founder of FinConecta, 2020)9

4.3 Successful FinTech example

A good example of a disruptive Fintech company is TransferWise. This company is an electronic money institution regulated by the Financial Conduct Authority of the United Kingdom. The aim of TransferWise is to provide worldwide money transfers at the lowest cost possible and at the actual currency rate. How TransferWise works is not complicated, TransferWise opened banks accounts around the world which gave the company access to the financial system in every country. So when the client sent money for example from the United States to another person or company in the United Kingdom TransferWise pays the person or company in the UK with funds that are currently in a bank account in the United Kingdom and the customer money goes direct to a TransferWise account located in the US, so that means that the money never left the country, saving the customer the cost of transfers and expensive fees of intermediaries banks.

TransferWise using the same concept has now a service called “Multi-currency account” that allows people and businesses to have multiple virtual bank accounts around the world making easier to send, receive and save money in different currencies and people can pay and withdraw money any time they want with their TransferWise Mastercard debit. Each time that a customer pays with the debit card pays at the current exchange rate, so users do not need to pay fees and if they do not have balance in that currency the principal balance is converted instantaneously at the real time currency exchange rate. (TransferWise mission report Q1 2018, 2018)10

5 Artificial intelligence in financial services

Artificial intelligence works solving human given objectives, making predictions, recommendations and or decisions about any given subject. All these processes are made with human input which is given as data.

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Details

Title
In the world of fintech and artificial intelligence (AI), do we still need hedge funds?
College
Pforzheim University
Grade
1,3
Authors
Year
2020
Pages
24
Catalog Number
V948625
ISBN (eBook)
9783346288202
ISBN (Book)
9783346288219
Language
English
Keywords
AI, hedge funds, funds, fintech, finance, Investment
Quote paper
Tim Zähringer (Author)Jose Carlos Villarreal Tovar (Author), 2020, In the world of fintech and artificial intelligence (AI), do we still need hedge funds?, Munich, GRIN Verlag, https://www.grin.com/document/948625

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