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Summary
Recent market volatility has highlighted the growing influence of AI on investment markets, with stocks increasingly moving together regardless of sector. This has reduced the effectiveness of traditional diversification and created challenges for some hedge funds, although many investment managers are adapting their approaches to navigate the changing environment.
It feels like it would be remiss not to write here about Wednesday’s Budget, but the date of publication for this blog is also Wednesday, so any predictions will be out of date as soon as they are read. In any case, John Healey has already told us to expect a ‘boring Budget’. This isn’t enormously inspiring from our new Chancellor given the UK’s economic predicament, and it makes it hard to believe the tide is about to turn, but we can all hope.
And now for something completely different
It has been an unusual few months for markets. Global equity indices have bounced along sideways since the summer and remain just a few percentage points off all-time highs. Passive investors could be forgiven for thinking nothing has happened, and yet the relative calm at index level masks the excitement going on underneath.
So far in October, the relative performance of value stocks compared to growth stocks in the US is in the top 2% of months, looking back over the past 20 years. That’s certainly notable, but on its own it doesn’t explain the extent of the pain some hedge funds have been experiencing, with reports last week that the sector in aggregate suffered its worst daily loss since COVID. So, as we approach Halloween, is something spooky happening?
I’m AI, and so’s my wife
According to data compiled by Exent, 73% of S&P 500 earnings calls in Q3 2026 mentioned AI, up from 42% in Q4 2023, with the average call mentioning it 13 times. AI is everywhere, and for good reason, but many companies could be accused of over-egging their credentials, desperate to claim they are the next big AI story.
This reminds me a little of the crypto craze in late 2017 when Bitcoin peaked up more than 1700% over the year to mid-December. In response, several companies rebranded by adding ‘coin’ or ‘blockchain’ to their name. One of the most famous cases of this was Long Island Iced Tea Corp., a beverage company based in New York, which rebranded to Long Blockchain Corp. This saw its share price briefly skyrocket but ultimately led to an insider trading investigation and bankruptcy.
What we are seeing now isn’t quite on the same scale, but it is clear there is a valuation premium being placed on perceived AI winners, and management teams are keen to claim this premium for themselves.
I am your king
Well, I didn’t vote for you
When everything is AI, this creates a problem for portfolios: seemingly unrelated stocks become correlated, whether we voted for it or not. Attempts to diversify across sectors and themes are futile if a single overarching factor is really driving returns. One hedge fund manager said to us earlier this week that when UK utilities start trading like a cyclical asset (because of linkages to the AI buildout) there really isn’t anywhere to hide.
Part of the reason October has been so violent is that many of these funds found themselves perilously close to their drawdown limits following a tricky July, when the AI trade first came under serious scrutiny. Consequently, further losses forced position closeouts, adding even more momentum to the adverse market moves. These sorts of positioning washouts are a known pitfall of hedge fund investing, but they are happening more frequently and more violently than in the past.
When assessing how our hedge fund managers invest in the current market environment, we are looking for subtle but meaningful tweaks to process rather than wholesale changes. One has shortened the time frame over which they assess statistical relationships between assets, while another has added explicit AI factors into their risk models. All this is eminently sensible and should ensure that, for our managers at least, the latest bout of volatility remains just a flesh wound rather than something more terminal.
Key takeaways
- AI is everywhere and has found its way into areas of the market that were previously unrelated to tech.
- Diversification is increasingly difficult to find, as higher correlations between stocks make it harder for investors to reduce risk using offsetting bets.
- Hedge fund managers are evolving their processes, updating risk models and investment frameworks to better reflect the ubiquity of AI.
CJ Cowan
Portfolio ManagerCJ is a portfolio manager of the Quilter Investors Cirilium and Monthly Income Portfolios. CJ joined Quilter Investors in August 2018 from Aberdeen Standard Investments where he worked in the global macro team, managing global government bond and global aggregate portfolios.
CJ is a CFA charterholder and has also completed the Chartered Alternative Investment Analyst qualification. CJ has a degree in economics from the University of Bristol and an MPhil in Economic and Social History from Brasenose College, University of Oxford.
