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BUSINESSTECHNOLOGY

Letting the Machines Decide

NewWaveofInvestmentFirmsLookto'ArtificialIntelligence'inTradeDecisions
BySC OTTPATTER SON
UpdatedJuly13,201012:01a.m.ET

WallStreetisnotoriousfornotlearningfromitsmistakes.Maybemachinescandobetter. Thatisthehopeofanincreasingnumberofinvestorswhoareturningtothescienceofartificialintelligence tomakeinvestmentdecisions. Withartificialintelligence,programmersdon'tjustsetup computerstomakedecisionsinresponsetocertaininputs. Theyattempttoenablethesystemstolearnfromdecisions, andadapt.Mostinvestorstryingtheapproachareusing "machinelearning,"abranchofartificialintelligenceinwhicha computerprogramanalyzeshugechunksofdataandmakes predictionsaboutthefuture.Itisusedbytechcompanies suchasGoogleInc.tomatchWebsearcheswithresultsand NetFlixInc.topredictwhichmoviesusersarelikelytorent.

OneupstartintheAIraceonWallStreetisRebellion Research,atinyNewYorkhedgefundwithabout$7millionin capitalthathasbeenusingamachinelearningprogramit Digits developedtoinvestinstocks.Runbyasmallteamof WhatIsArtificialIntelligence? twentysomethingmathandcomputerwhizzes,Rebellionhas Using'AI'toDigestNews,TradeStocks asolidtrackrecord,toppingtheStandard&Poor's500stock indexbyanaverageof10%ayear,afterfees,sinceits2007launchthroughJune,accordingtopeople familiarwiththefund.Likemanyhedgefunds,itsgoalistobeatthebroadermarketyearafteryear. "It'sprettyclearthathumanbeingsaren'timproving,"saidSpencerGreenberg,27yearsoldandthebrains behindRebellion'sAIsystem."Butcomputersandalgorithmsareonlygettingfasterandmorerobust." SomesophisticatedhedgefundssuchasRenaissanceTechnologiesLLC,basedinEastSetauket,N.Y., aresaidtohavedeployedAItoinvest.Butforyears,thesefirmsweretheexception.Somefirmsthathave dabbledinAIareskepticalitisanywhereclosetoworking. Rebellionispartofanewwaveoffirmsusingmachinelearningtotrade.CerebellumCapital,aSan Franciscohedgefundwith$10millioninassets,startedusingmachinelearningtoinvestin2009.Anumber

Ahedgefundstartedbyfouryoungmathwizardsis usingabranchofartificialintelligence,called "computerlearning,"tomakeinvestmentdecisions. RebellionResearch'sfour,20somethingyearold partnersexplainhowtheircomputerprogram"thinks" uptheirstrategy.

ofhighfrequencytradingfirms,suchasRGMAdvisorsLLC inAustin,Texas,andGetcoLLCinChicago,areusing machinelearningtohelptheircomputersystemstradeinand outofstocksefficiently,accordingtopeoplefamiliarwiththe firms. Theprogramsareeffective,advocatessay,becausetheycan crunchhugeamountsofdatainshortperiods,"learn"what works,andadjusttheirstrategiesonthefly.Incontrast,the typicalquantitativeapproachmayemployasinglestrategyor evenacombinationofstrategiesatonce,butmaynotmove betweenthemormodifythembasedonwhattheprogram determinesworksbest.

'Humanbeingsaren'timproving,'saysRebellion Research'sSpencerGreenberg,foreground.With him,fromleft,areJeremyNewton,JonathanSturges andAlexanderFleiss,alsoofRebellionResearch, outsidethecompany'sNewYorkofficeslastmonth. MichaelRubensteinforTheWallStreetJournal

"Nohumancoulddothis,"saidMichaelKearns,acomputerscienceprofessorattheUniversityof PennsylvaniawhohasusedAItoinvestatfirmssuchasLehmanBrothersHoldingsInc."Yourheadwould blowoff." Rebellionhasstruggledtoraisemoney,inpartbecauseinvestorssincethecreditcrisisaredubiousof opaquemathbasedstrategies. Thefirmhasattractedatleastonelongtime"quant"skeptic: famedvalueinvestorJeanMarieEveillard,whorecently investedseveralhundredthousanddollarsofhisownmoney intoRebellion."Mycupofteaisnotquantitativeinvesting,"he said."ButIthinktheyareseriousinvestors,andI'm impressedbythefactthattheydon'thaveahighturnover anddon'tuseleverage." Rebellion'sMr.Greenbergisnostrangertotheinvesting world.Hisfather,GlennGreenberg,isaniconoclasticvalue investorandmanagerofBraveWarriorAdvisors,who recentlysplitfromhispartnersatChieftainCapital ManagementInc.Hisgrandfather,legendarybaseballslugger "Hammerin'Hank"Greenberg,playedfortheDetroitTigersin the1930sand'40s.

Fromleft,RebellionResearch'sAlexanderFleiss, JeremyNewton,JonathanSturgesandSpencer Greenbergonarecentday.MichaelRubensteinfor TheWallStreetJournal Tradingisazerosumgame.Evenifthecomputers aretradingagainstcomputersmoneywillstillbemade becauseeveryone'smodelisdifferent. SetsunaSeiei

Pastsuccessdoesn'tmeanRebellionwillcontinuetobeatthe market.Aswithmanyquantstrategies,itssystemcouldstop workingifmarketfundamentalschangeinwaysthattripupitscomputerprogram,knownas"Star." WhatmakesStarintelligent,saysMr.Greenberg,isitsabilitytoadjustitsstrategybasedonshifting dynamicsinthemarketandbroadereconomy.Theprogramisn'twedtoanysingleinvestingapproach. Undercertainconditions,thefundwillbuycheapstocks,inothersitwillfavorstockswithswiftlyrising pricesorbothatthesametime. Unlikethehighfrequencyfundsthatuseartificialintelligencetoaidrapidtrading,Rebelliontendstohold stocksforlongperiodsonaveragefourmonthsbutinsomeinstancesmorethantwoyears.Italsodoesn't shortstocksoruseleverage,orborrowedmoney,whichcanamplifyreturnsbutalsoboostrisks.

Theprogrammonitorsabout30factorsthatcanaffectastock'sperformance,suchaspricetoearnings ratiosorinterestrates. Theprogramregularlycrunchesmorethanadecadeofhistoricalmarketdataandthelatestmarketactionto sizeupwhethertobuyorsellastock.Whencertainstrategiesstopworking,theprogramautomatically incorporatesthatinformation,"learns,"andadjuststheportfolio. Forinstance,itmaydetectdataindicatingstockswithlowpricetoearningratiosarelikelytoriseandload uponthosestocks.Then,iftheprogramlaterfindsthatthestrategyislikelytolosesteam,basedonshifts inthefactorsittracks,itwilldumpthosestocksandbuystocksitdeemsmorefavorable. Everymorning,Starrecommendsalistofstockstobuyorselloftenitoffersnochangesatall.Ahuman traderimplementsthemoves.Thefirmsaysitneveroverrulesthecomputerprogram,whichislargelythe samesystemtheystartedwithin2007,withafewnipsandtucks.Rebelliontypicallyholdsabout60to70 stocksatanytime. Mr.GreenbergstarteddesigningStarinmid2005,soonafterhegraduatedfromColumbiaUniversitywithan engineeringdegree.HewasjoinedbyAlexanderFleiss,ahighschoolfriendwithabackgroundinfinance andmath,aswellasJonathanSturges,whohasamaster'sdegreeinmusiccomposition,andJeremy Newton,amathematicianwhohelpeddesigntheAIprogram. InJanuary2007,with$2millionincapital,theprogramstartedpickingstocks.Thatspring,itstartedmoving intodefensivepositionssuchasutilities.Rebelliongained17%in2007,comparedwiththe6.4%gainbythe DowJonesIndustrialAverage,accordingtopeoplefamiliarwiththefund. Itstayeddefensivethroughoutmostof2008,holdinggold,oilandutilitystocks.Still,itlostmoneylikemost investors,sliding26%buttoppingthe34%declinebytheDowindustrials. Inearly2009,Starstartedtobuybeatendownstockssuch asbanksandinsurers,whichwouldbenefitfromarecovery."Hejustloadeduponvaluestocks,"saidMr. Fleiss,referringtotheAIprogram.Thefundgained41%in2009,morethandoublingtheDow's19%gain. Thefirm'scurrentportfolioislargelydefensive.Oneofitsbiggestpositionsisingoldstocks,accordingto peoplefamiliarwiththefund. ThedefensivemoveatfirstworriedMr.Fleiss,whohadgrownbullish.Butithasprovenasmartmoveso far."I'velearnednottoquestiontheAI,"hesaid. WritetoScottPattersonatscott.patterson@wsj.com
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