The Plight of the Lemming Robo-Advisor

(c) Nature Picture Library / Alamy, all rights reserved
(c) Nature Picture Library / Alamy, all rights reserved

There is a popular misconception about Lemmings. It is said that they commit mass suicide by jumping off cliffs when their population becomes too dense. However, this is quite far from the truth. Instead of committing suicide Lemmings will seek pastures new when their environment no longer serves their biological urges. As Lemmings can swim, they then may choose to cross a body of water in search of a new habitat. However, when doing so, many may drown as the fjords or rivers are too wide, thus stretching the Lemmings’ physical capabilities beyond their limits.

Financial markets and Lemmings

What is true, however, is that large populations of Lemmings move in one group, and it is this group migration that influences the moves of the individual Lemming. Once a significant share of the group has entered the water, the other Lemmings are likely to follow suit, inconsiderate of the potential fatality of their choice. Financial markets are not so different. Benchmarks are extensively being used and research in the field of behavioral Finance has yielded strong indications that herding behavior is rather pronounced. The broadly hailed Robo-Advisors of the Fintech age are likely to amplify this problem.

Mushrooming Robo-Advisors

Robo-Advisors are sprawling across the globe. A Robo-Advisor can be defined as a self-guided online wealth management service that provides automated investment advice at low costs and low account minimums employing portfolio management algorithms. Clearly, while there are exceptions, Robo-Advisors typically build client portfolios from ETFs, more specifically from equity ETFs. This model has worked fairly well as long as the stock markets were going up.

ETF monocropping

However, what will happen when the markets turn south? Most Robo-Advisors are not older than five years. Over the past five years the Euro Stoxx 50 went up 32%, the Dow Jones soared by 68%, and the S&P 500 grew by 78%. Against the backdrop of these well performing indices it requires no magic to put together a well performing client portfolio. Yet, in declining markets, the index-pegged Robos will just perform as poorly as their benchmarks.

No hedging functionalities

Evidently, the heyday of hedge funds are over. Clients are no longer willing to accept a 2/20 fee structure no matter the performance of their investment. Yet, as soon as markets move down for a prolonged period, many investors will start to liquidate ETF positions. These divestments will fuel another round of decline in indices. In this situation Robo-Advisors will be rather useless as they typically have no built-in hedge functionality. The herd of Lemming-Robos will just follow the rest of the market into deep waters.

Robo-Advisors must evolve

Not all is lost yet. Robo-Advisors need to make the next evolutionary step and get prepared for wider market downturns. Consequently, they should consider incorporating hedging functionalities into their offerings. Gambling on ever increasing stock markets is just too risky of a gamble. However, if the supply side, does not act, then the demand side should swing into action and diversify their ETF portfolios. Clients may therefore want to invest part of their assets into hedged investment structures of different provenance.

No matter the cause of the next financial market downturn, it is safe to say that it will happen. Lemming Robos which will not have enhanced their offerings by then, will not serve their clients well. A broad decline of equity indices may then lead to a true renaissance of the hedge fund industry. Human driven alpha generating strategies will then take back the lead from beta generating Robo-Advisors.

Dr. Patrick Schüffel, Professsor, Institute of Finance, Haute école de gestion, Fribourg Chemin du Musée 4, CH-1700 Fribourg, patrick.schueffel@hefr.ch,www.heg-fr.ch

Do you work for a bank in decline? Four criteria to check

Back to the Future 1985, (c) Universal Pictures
Back to the Future 1985, (c) Universal Pictures

In 1984, one year before the sci-fi classic “Back to the Future” was released, the professors Danny Miller and Peter Friesen from McGill University in Montreal published a seminal paper on corporate life cycles. Both works contained clairvoyant features for the future.

Building on an empirical sample of firms the paper titled “A longitudinal study of the corporate life cycle” describes how companies can be classified into five life cycles from birth to decline. The authors applied five dimensions to accomplish this task: strategy, structure, environment and decision making style.

Fast forward 30 years. The year 2015 which was vividly described in “Back to the Future Part II” has just passed and an entire economic sector, namely the banking industry, appears to be in the doldrums. Many banks seem to be in decline.

Do you work for a bank in decline? Let’s have a quick lock how Miller and Friesen verbatim characterized a declining firm along the four dimensions thirty years ago (emphasis added):

1.   Strategy

“Firms in the decline stage react to adversity in their markets by becoming stagnant […]. Firms seem to be caught in something of a vicious circle. Their sales are poor because their product lines are unappealing. This reduces profits and makes for scarcer financial resources, which in turn cause any significant product line changes to seem too expensive. So product lines become still more outdated […]; the firms just muddle through.”

2.   Situation

“[…] There is a tendency to attend to what the owners want, that is, to preserve resources, rather than cater to the needs of customers. The market scope of declining firms is quite narrow […]. Failure in one major product line simply cannot be counterbalanced by success in others as might happen in more diversified companies […]. Shrinking markets can be extremely competitive and firms that rely totally upon them may find themselves in deep trouble. Performance thus tends to be very poor. This may be caused partly by the simple structure.”

3.   Structure

“The locus of decision-making power is at the top of the firm. In fact, even routine operating decisions (these predominate in declining firms which shy away from strategic decisions) are executed by higher level managers […]. While managers who are close to customers and markets may be well aware of the problems that exist, their information does not seem to filter up to those with enough authority to do anything about it.”

4.   Decision-making Style

Decision making is characterized by extreme conservatism. There is little innovation, an abhorrence of risk taking, and a reluctance even to imitate competitors’ innovations, let alone lead the way […]. Sometimes it is due to the temperament of the top managers. Occasionally, it results from funds shortages stemming from previous declines in performance. But almost inevitably, key contributing factors are ignorance of markets […]. Managers fail to delegate and there is little in the way of participative management. Thus the top executives must spend most of their time handling crises. They just haven’t the time for much analysis. So they take very few dimensions into account in decision making […] and employ very short time horizons.”

Resonating with today’s banking industry

This rich description of a declining firm crafted in the year 1985 may resonate with many people across the globe working for banks in the year 2016. If it rings a bell with you, your bank may well be in decline. However, not all hope is lost: in their empirical study Miller and Friesen also showed that 42% of the firms in the decline phase progressed to the revival phase. But don’t get your hopes up too soon: Miller and Friesen describe the survivor bias as one of the major shortcomings of their study. Their empirical study only contained surviving firms. Those which did not make it through the decline phase were not included in their research.

Unfortunately, it appears as if Miller and Friesen’s 1984 description of declining firms had quite some clairvoyant features for many a bank of the year 2016.

Source:

Miller, D., & Friesen, P. H. (1984). A longitudinal study of the corporate life cycle. Management Science, 30(10), 1161-1183.

Dr. Patrick Schüffel, Professsor, Institute of Finance, Haute école de gestion, Fribourg Chemin du Musée 4, CH-1700 Fribourg, patrick.schueffel@hefr.ch,www.heg-fr.ch

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