Robo-advisors Are They That Smart?
Robo-Advisors are a hot topic that has come up many times lately, and I think I (as a former programmer and current IT person) have a unique perspective on this topic (having a journeyman’s understanding of financial matters as well). Are Robo-Advisors something new, or just old tricks wrapped in technology?
A simple explanation of this investing vehicle from Wikipedia is:
Robo-advisors are a class of financial adviser that provides portfolio management online with minimal human intervention.
What qualifies as a Robo-advisor? Pretty much anything is a very loose set of heuristics and ideas, along with some technical flimflammery. My first piece of advice is if anyone says they have a Robo-Advisor taking care of their investments, ask them if they understand what they are using. Handing your money over to an (allegedly) automated system you don’t understand is just as bad as handing it to a Human Advisor with little or no talent in investing. A task is poorly done by technology, or a human is still a task poorly done.
An important thing to remember is the Robo-advisor simply does what it is programmed to do. It “decides” based on what it is told to do (it does not learn or diverge from its programming). Many marketing blurbs speak of expensive algorithms that assure maximum investment performance, but I am skeptical.
A key thing to understand in this area is the investing philosophy the Robo-advisor will follow. Here is a simple philosophy and method to go with it.
Passive Investing with Quarterly Balancing
Philosophy: set up a diverse portfolio with the following configuration:
- 25% Canadian Index Fund
- 25% US S&P 500 Index Fund
- 25% International Index Fund
- 25% Canadian Bond Fund
You recognize that as a simple couch potato configuration. Buy low mgmt fee ETFs or Index Funds.
Algorithm: Every three months, compare holdings percentages, and if any position is greater than 5% off 25% (plus or minus) rebalance using existing funds.
This is what a Robo-Advisor might do for you (note you can do this as well, you are simply automating it). From a simple point of view, this seems like a relatively good way of doing things, or does it?
What the philosophy doesn’t say:
- What funds or ETFs should be used, so what stops the programmer of the Robo-Advisor to have you buy funds with a company that might pay them a fee? This kind of “buying bias” is already being seen in the marketplace.
- What stops the program from suddenly changing funds and churning your money (i.e. losing it to purchase fees and such)?
- How much are you going to pay for the service? Are you paying for something you could just as easily do yourself (yes, I realize many folks don’t want to do this, but that does not mean they should be paying through the nose for the privilege either).
These are just some very simple questions to ask.
I’d really like to see some kind of regulation or standards in the area of Robo-Advisors, but I suspect specific regulation may not occur until there is a scandal of some sort (in the area).
Hey Cajun,
I agree – I can’t see a benefit from a robo-advisor. You can beat it easily yourself. The cost is typically about half of that of a human advisor, but without advice.
The robo-advisor portfolios tend to make the same portfolio errors we are all warned about. They are heavily over-weight Canada. They buy whatever is currently trendy and expensive – which today is “low volatility” ETFs or high dividend ETFs. By buying popular ETFs, they have built in “buy high sell low” into their algorythm.
To beat them, buy one global all-cap ETF (and possibly one bond ETF). The global ETF is properly allocated (not over-weight Canada & resources) and the ETF rebalances automatically within itself. Plus the global ETF does not buy popular ETFs.
Buying one global ETF is using indexing. Using a robo-advisor is a weak stab at active management.
For fees, a human fee-based advisor typically charges 1% of assets. Robo-advisors are about .5% – or half the cost.
What do you get? With a robo-advisor, you get rebalancing – which you can eliminate by buying one global ETF. Essentially, you get nothing, except ease of investing.
With a human advisor, there can be significant benefits. Investing and financial planning has a huge behavioral component. People tend to buy the wrong investings by buying whatever is popular. ETF investors are classic in this with 80% of ETF assets being in currently popular and over-priced ETFs at any time.
Studies show that investors with an advisor have on average 2-4 times larger portfolio than DIYers – after accounting for age and income.
For most people, a human advisor is worthwhile, but a robo-advisor is not.
Ed
I think my major concern is that folks seem to think that technology is a panacea, but it if it programmed badly, or its underlying decision process is the same flawed system that current investment professionals use, it is just faster wrong decisions.
Ed,
Where, in Canada, would one find an advisor who only charges 1% of assets in fees? To my understanding they charge between 1.5% to 2% depending on portfolio size. The advisor I had between 1999 to 2008 charged 1.75%.
Good post. Thanks. Investing with a 3-fund ETF portfolio is shockingly simple and easy. The investing industry loves to conflate financial planning, investment advice and investment management to make it look too complex for an individual to do. The media and bloggers need to continue to emphasize this, and how important simplicity and low cost are in investing.
Many robo-advisors would be better than buying high-fee mutual funds or market indexed GICs for people that don’t want to do DIY. Many of them are not very open about what funds they hold and how the portfolios are designed, hiding it behind high-falutin “algorithms”. They are really a marketing driven half-step to true low cost long-term investing.
For the life of me I can’t understand why anyone would use a robo-advisory service to manage an index fund portfolio unless the service was free. It’s so simple and cheap to manage indexes yourself. This isn’t rocket science.
Aaahhh, but Rocket Science DOES use computers, makes you think (sarcasm).
A DIY index investor with an abacus could match the rebalancing skills of the robo-advisor (irony)…lol
Agreed, but I am assuming most of the robo-advisors use more complicated heuristics.
Automated tax loss harvesting, would be the one reason I would use a robo-advisor.
Actually crystallizing a loss, even if it is just to buy the same thing (follows a different benchmark.. whatever), is a little scary.
… and making sure that the “algorithm” used isn’t doing this to bump up commissions as well.
In fairness to the people who offer Robo-advisor service commissions are not charged on top of the Robo service fees. That said some discount brokers offer index funds free of commissions. I like free and would go this route if I were to invest in index funds.