Thursday, June 30, 2016

Algorithms stayed the chaos during Brexit storm: Can they help with auditor judgment?

The recent Brexit crisis hit the markets hard with the various stock indices plummeting and investors fleeing for the safe haven of gold, which went up "by $59.30, or 4.7 percent".

Amid this  chaos, some investment strategies fared well - thanks to the use of robots.

According to the WSJ article, "Who Made Money in the Brexit Chaos? Machines, Not Humans",  machines were immune to the fear, uncertainty and doubt that plagued markets (italics, highlight mine):

"This fund category, sometimes called commodity trading advisors, or CTAs, uses customized trading algorithms to spot market trends and place bets on futures and other derivatives. Most of the models didn’t factor in British election polls, bookmakers’ odds or the political-tea leaf reading that swayed other investors looking for an edge. In the weeks leading up to the Brexit vote, the trading models at many of these firms adopted a defensive pose. They favored high-quality government bonds, gold and safer currencies like the yen, while mostly avoiding riskier bets like oil and emerging markets.

That positioning paid off after Brexit caused the pound and more volatile assets to plunge as Thursday’s results came in. Société Générale’s CTA Index gained 1.5% on Friday. AQR Capital Management LLC, Fort and Welton Investments Partners LLC were among the big gainers... A key to CTAs’ success, their managers say, is that their models can tune out noise around market moving events—like an election or crucial economic data—that are important to investors but can be difficult to accurately forecast."

The article also quoted Lara Magnusen, portfolio strategist for Altegris’s main fund, who said (bold mine):

"Our models aren’t going to be affected by the same sentiments a human would be"

I thought that this was interesting as it illustrates how the machines can be seen as a way to provide an anchor when people are getting caught up in an emotional frenzy. Think of the implications for the world of audit and assurance, where professional judgement are made to determine what accounts, transactions, etc. are risky and should be tested. Imagine an audit algorithm that can be as an independent monitor that vets judgments of the audit professional - in a "race with a machine" scenario (for more on this idea see the Ted Talk below with MIT professor Eric Brynjolfsson). This could potentially improve auditor judgment, stakeholder confidence and audit quality.

Initially, I think this would be a way for audit firms to reduce the level of uncertainty associated with reviews from the PCAOB, CPAB and their equivalents in other jurisdictions. This would especially be the case if such audit oversight bodies would "bless" such algorithms and be able to ensure that the firms applied such judgment consistently, e.g. by having access to the "audit logs" produce by such programs.

The next - and more controversial step - would be to argue that independence rules can be relaxed in light of such automated oversight. To be honest I think there's a low likelihood of such an idea making traction with regulators in the near future, given that Europe has sought to require mandatory rotations of auditing firms. But it is something that should at least be contemplated, especially when automation becomes commonplace and attitudes may change towards how algorithms can play nicely with humans.

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