Commerzbank tries to ape the brain to earn more returns

LONDON: Imagine a mathematical system that works like a human brain, can absorb thousands of bits of information in seconds, adapts 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, but it’s something similar. A neural network is 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 said 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, ” 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% last year.

According to data complied by Commerzbank, new money going to these 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.

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.

“An analytical model would probably pick that up right away. It would show up with the traditional way of managing funds of hedge funds, but only probably when it’s too late ... When you have a disaster scenario like last month,” Mattoo said. “You should be able to pinpoint potential problems in advance ... The analytical side can be extremely useful for example with correlations.”