Is AI Technology The Biggest Risk For Hedge Fund Growth And Market Stability?

Forbes

27-03-2025

The U.S. Senate Committee on Homeland Security and Governmental Affairs is not at the top of anyone's list for hedge fund commentators but it does have serious views on the subject.
Its report in June last year said that hedge funds use of AI and machine learning technologies to assist in trading decisions, which has been a practice by some for years, raises several concerns as this technology evolves, including the risk of inadequate disclosures to clients and the potential for increased threats to market stability.'
It quoted the then SEC Chairman Gary Gensler's view that a financial crisis triggered by AI is 'nearly unavoidable' within the next decade and cited the May 2023 incident when an AI generated image of an explosion at the Pentagon led to a drop in stock market indices. Gary Gensler is gone and AI regulation in the new administration is certain to be lighter but the issue remains.
Arguably, the biggest concern often raised by policymakers and regulators about AI in financial services is the use of GenAI and Large Language Models (LLMs) which are complex and nuanced, often with a lack of transparency with the underlying information used in generating a response that is used to make investment decisions. This is especially the case in the regulated financial services sector.
The CFTC released Report on Responsible AI in Financial Markets, in May 2024, was authored by an independent Commitee of experts to facilitate an understanding of the impact and implications of the evolution of AI on financial markets with five recommendations to as to how the CFTC should approach this AI evolution in order to safeguard financial markets - regulating AI in financial services was not one of the recommendations.
Commenting on the report, Commissioner Goldsmith Romero said, 'I herald the foundational, iterative approach of the Committee to recognize both that AI has been used in financial markets for decades, and that the evolution of generative AI introduces new issues and concerns, as well as opportunities."
'Herding' is often cited as a concern, where similar common models are used systemically important financial institutions or large cohorts of market participants, creating concentration risks, as pointed out in IOSCO's newly released member survey report, Artificial Intelligence in Capital Markets: Use Cases, Risks, and Challenges, though the report claims there is a lack of sufficient data in this specific area.
The European Commission is consulting the industry on the use of AI in financial services with a view to regulating it, which is more the European way.
Jack Inglis, ceo of The Alternative Investment Management Association (AIMA), says, 'A prescriptive approach to policy-making in this area could stifle innovation, placing European investment managers at a competitive disadvantage globally.'
AIMA, which represents many hedge funds, stressed advanced technologies have been used in the sector for years 'to increase business and compliance efficiencies, but generative AI now offers new opportunities for enhanced efficiency gains.'
Firms in the hedge fund industry, and across the financial services sector as a whole, invests heavily in their own technology, and in fintech and technology investments. After the Fed started rate cutting Goldman Sachs noted that hedge funds were buying technology stocks at the fastest rate for four months placing nearly almost three times as many long positions on the bet that information technology stocks would rise, compared to those with bets against them.
That has of course changed since the start of the year and coinciding with the launch of DeepSeek. The Magnificent Seven or Mag7, now dubbed the Lag7, are down 16 percent so far this year. Markets being markets, there are claims now that Lag7 stocks are oversold.
Goldman Sachs now says hedge funds are fuelling the biggest tech buying spree since 2021 with Clif Marriott in Goldman Sachs Global Banking & Markets saying, 'We think 2025 is going to be a breakout year for the number of tech IPOs globally.'
The amount of capital invested in artificial intelligence is growing and similarly in cyber security, 'European tech has evolved immensely over the past decade,'add Marriott.
Investment by hedge funds in technology for their own business operations as well as for their investors is a major issue and one that research from Beacon Platform Inc. has explored in depth in a new research report, Hedge Funds in 2024: Risks, Resilience, and Technology.
Asset Tarabayev, chief product officer at Beacon, sums it up the report saying, 'Hedge funds clearly understand that data and systems integration are essential components of both risk visibility and competitive advantage.'
The report from Beacon, a cross-asset portfolio analytics and risk management platform for multi-strategy hedge funds, contains some good news and some not so good news about hedge funds' use of technology.
The good news is that institutional investors are predicting strong growth and attractive risk-adjusted returns in the hedge fund sector and are planning to back expansion with increased allocations. Almost all (93 percent) questioned expect an increase in fundraising by hedge funds of 10 percent or more over the next three years with 14 percent predicting growth of more than 20 percent.
All institutional investors questioned believe investing in hedge funds will be attractive in terms of risk-adjusted returns over the next five years, with 17 percent describing it as very attractive.
Data from Hedge Fund Research shows that at the end of 2024 total global hedge fund capital rose to an estimated $4.51 trillion, increasing $401.4 billion in the year. A major growth area has been crypto and blockchain with the HFR Cryptocurrency Index showing annualized returns of 51.4 percent and cumulative gains of 694.6 percent over five years.
The not so good news is that, for all the investment in technology and talk of the use of generative AI and innovation, the research discovered the old ways have not gone away yet with 90 percent questioned saying their fund or department is wasting time with Excel spreadsheets and other manual activities.
Almost all (92 percent) believe their system spends too much time on consolidating data from multiple sources while 81 percent say too much time goes in investment evaluation and 79 percent admit time is wasted on aggregating and measuring risk.
Nearly three out of four (73 percent) say too much time goes into manual or spreadsheet-based analytics and 71 percent say this about trying to define P&L residuals.
Kirat Singh, co-founder and ceo, at Beacon said: 'Excel spreadsheets clearly have a place in managing trading activity and risk management in the hedge fund sector, however, with so many saying that they are spending too much time on spreadsheets, there is a strong case for greater use of the available technologies.
'Leading funds are turning massive spreadsheets with millions of cells into cloud-enabled analytics, increasing the scale and speed of their analysis and decision making.'
Technology and its use in risk management emerged as one of the biggest risks. Most institutional investors questioned (88 percent) agree that the quality of information and transparency in hedge funds needs to improve, with 22 percent saying it needs to improve dramatically.
It is an issue that is costing hedge funds money.
85 percent of institutional investors questioned have decided not to invest in a particular fund because of concerns over its management of risk, and almost all (93 percent) think that this will be a growing trend.
Almost all (93 percent) of senior hedge-fund executives questioned said risk parameters are becoming stricter at their firm in terms of what they can and cannot trade. Almost all (95 percent) say they are having to reduce or abandon trading in some areas because of the growing risks or because they don't have a good enough understanding of the risks in that area.
Credit trading is the area hedge fund executives believe is most likely to be reduced or abandoned due to tighter risk parameters.
Technology is the answer or at least a big part of the answer in helping to improve risk management. Almost all (99 percent) of hedge fund executives questioned say their fund will increase spending on risk management over the next two years. 90 percent questioned admit transparency provided to clients and investors must improve with 23 percent saying it has to improve dramatically.
More than half (55 percent) say investment in technology is helping improve risk management and technology is seen as a source of competitive advantage across a range of factors. It is also a major factor making it easier to launch new funds with 60 percent of hedge fund executives questioned pointed to technology as a driver for growth in the number of funds.
Technology is just about as important as being able to raise funds with 61 percent questioned indicating this.
The research found launching a new fund is so popular that most hedge fund executives suspect colleagues are planning to quit and launch their own fund with 85 percent of senior executives questioned are concerned about a colleague launching their own fund. They just need the technology, which is becoming both cheaper to buy and build.
Technology is central to the development of the hedge fund industry and will continue to be so for the foreseeable future, however it is often a tale of two domains from LLMs to spreadsheets.
While the U.S. is focused more on voluntary guidelines for AI use in industries like financial services, the EU AI Act looks to be focused on comprehensive regulatory efforts, and classifying AI systems in high risk areas like financial services and healthcare.
A good common ground for the hedge fund industry and policymakers and regulators is transparency - technology that delivers the transparency and outcomes that investors increasingly require will go some way to satisfying the drive to better oversight.
The use of newer and greater technology monitoring systems to underpin financial stability would be a great and innovate breaththrough and improvement - physician, heal thyself.
It is time that governments and regulators master this new and innovative technology to satisfy the monitoring (RegTech) and supervisory (SupTech) requirements in industries like financial services that are technology driven to meet the requirements of our complex society.