Coming To Disrupt A Financial Industry Near You: Robo–Advisors

The Internet continues to chug along and blow up traditional long standing industries. Newspapers, Hollywood, book publishers, and even taxi cab drivers have seen their livelihood’s threatened by an innocent screen with a bunch of hyperlinks. Where will the world wide web focus its tentacles next? Well it looks like the world of financial advisors is about to get some cold water splashed on its face. In the U.S. several companies have made a bit of a splash offering a service that will manage their investments online using sophisticated algorithms to automatically select appropriate investments based on the client’s risk and demographic profile. The kicker is that because of the minimal overhead, they can charge ultra-low fees. The premise is that the traditional financial advisory model is broken because advisors are focused on selling product rather than genuinely working to help people meet their financial goals. These firms are also targeting a younger demographic who is less interested in working with someone in person and would prefer to take a hands off approach. The rise of these “Robo–Advisors” is seeing them fill a need for new investors who have minimal cash to invest and thus get little time or day from traditional financial institutions.

As an investor, what’s not to like about this new type of financial arrangement? Answer a few questions online about my life and risk tolerances, link up my accounts to automatically deposit on a monthly basis, and let a computer run with it and pick my investments for me at a minimal cost. It’s almost too good to be true. Is it? Well I thought I would mind map the pro’s and cons of what could be a model that could be coming to disrupt the financial industry.

THE PRO’S

They get people in the game 
The earlier one can start investing, the better their chances of building a meaningful nest egg for their wonder years. A lot of people are intimidated about finance and money. They don’t know where to begin. A Robo–Advisor service appears to be a rather pleasant way to get into the game. Traditional financial institutions like to talk to down to people and make it sound like they know all and you don’t. I’ll admit that can be intimidating. Linking up to a website that won’t talk down to you could be a more appetizing experience. Also because younger people are much more tech savvy, they find using an online service to be less intimidating.

They take the emotion out of investing 
One of the great challenges of investing is to avoid making decisions that are driven by emotion. When stocks go down for a meaningful period of time, our human reaction is to sell what we’ve got when in fact we should be buying stocks and companies that are getting thrown out with the bath water. Same goes when stocks are in a bull market and we feel compelled to buy any stock at any price just so we can feel like we are keeping up with our friends and neighbours who are gloating about the killing they are making in stocks. More often than not when we let emotion cloud our decision making, it often doesn’t end up well. The Robo–Advisors claim they because they have programed almost every possible market outcome, that their algorithms will prevent investors from making these ill-fated decisions. The computer will know when to buy and sell. When the stock market crashes, the computer will not panic. It will rely on its algorithms and calmly execute the appropriate action. As a result, the Robo–Advisor model claims it will keep you in check during an extreme market moment. This sounds more appealing because Financial Advisors and coaches spend a lot of time just preventing their clients from getting in their own way. Maybe it is better to have a computer manage it?

They don’t discriminate based on your bank account 
The way the financial services industry is working now, if you don’t have at least $100,000 in your portfolio, they really don’t want to have anything to do with you. In reality, you probably need about $200,000 or above to get any love from most financial institutions. You can’t blame them; larger assets mean potentially larger fees and commissions. Because of this the new investor or the investor with a small amount of savings have very little advisory options. That could explain why investment coaching has seen a push as investors seek to educate themselves to make better investment decisions because the industry really doesn't have the time for them. Financial Advisors need to realize that these type of clients that they ignore now could become potential clients in the future if their experience with Robo–Advisors is possible and they are able successfully accumulate a critical mass of wealth.

The Robo–Advisor model does not discriminate on the basis of account size. Using a Robo–Advisor service requires at a minimum $10,000 so anyone can get access to some level of advisory service.

Risk is a key driver in their portfolio design
In the series of posts I prepared on how to work with a financial adviser I referred to the hidden camera expose by CBC’s Market place program where they sent hidden camera’s into the wealth management branches of the large financial institutions. In their examination, it was startling to see financial advisers recommending highly risky products without even discussing about the client’s risk tolerance or history with risk. Investing is about risk management and making decisions that you can deal with. It factors into every financial decision that is made. From this perspective it is comforting to see that Robo–Advisor makes risk evaluation a core component in designing and managing their portfolios.

Cheap fees
Minimizing commissions and management fees is a must for any portfolio and the financial services industry is notorious for their opaque compensation structure. Ask a financial services associate about their company’s fee schedule and either they will dodge or it give something extremely vague. You can make wonderful investment decisions, but if your portfolio is getting skimmed 2-4% annually on fees you are throwing out a lot cash. The industry although claiming that they are listening and trying to be more transparent about fees has made little headway. Granted commissions have fallen in recent years thanks to greater penetration of passive investment products like Exchange Traded Funds (ETF’s) and index funds, however they makeup an extremely small percentage of assets invested. Robo–Advisors have been extremely upfront and transparent on their fee structure. Some even charge no fees on accounts less than $10,000 and then work on a sliding scale based on percentage of assets. It’s all upfront and there is little that is hidden.

A passive investor’s delight 
Robo–Advisors asset selection consists primarily of ETF’s and index funds, although one company does include individual stocks in their model portfolios. Overall though the Robo–Advisor investment strategy involves designing a portfolio that has a mix of low cost ETF’s that are automatically rebalanced periodically or as its algorithms deem so. There is enough analysis that has shown that a passive strategy of owning index-oriented funds can outperform actively managed funds that are traded and churned over to death. So if you really don’t think you can commit the time to learning about analyzing individual stocks and want to have a meaningful exposure to stocks, the Robo-Advisor service might suit you.

As we can see, there is a lot to like about Robo–Advisors. There are also some unknowns about the business and I’ve mind mapped a few for consideration:

THE CONS

No history
Like any product we purchase, we want to have some comfort knowing that it has been stress tested and can withstand shocks to the system. As the Robo–Advisor model is fairly new, it really hasn’t operated under a variety of financial conditions, even though the proponents of the service claim they have programmed every possible situation and then some for every possible demographic and risk profile. As we saw in the 2007-08 financial meltdown, many of the quantitative investing models and derivatives like collateralized debt obligations that were supposedly stress tested did not hold up when a couple of brokerages decided to go under. We just don’t know how effective these algorithms are under extreme economic conditions.

The Robo companies claim they have not just programmed market gyrations but your own personal life changes into their models. From the Betterment website:

“If your circumstances change – say you get engaged and need to start saving for that honeymoon, or you have a child and it’s time to save for college – our advice and the handy slider tool are always there for you to adjust your allocation when you need to do so.”

No Shoulder To Cry On
When you turn on your smartphone and see the alerts of a major negative event in the stock market, your tendency would be to speak to someone to understand the situation and more importantly keep your emotions in check so you don’t do something that conflicts with your investment strategy. With Robo–Advisors, except for someone on a chat line who you can text to, there really aren’t any “people” who you can talk to who will have an intimate understanding of your portfolio and your personal risk tolerances. You’ll have to be happy to settle for an agent. If you are about relationships, Robo–Advisors will not give you that shoulder to cry on or bounce ideas off compared to working with an investment coach or a traditional financial advisor.

Do computers have a fiduciary duty?
Like traditional advisors, Robo–Advisors will also be evaluated on the level of fiduciary duty and care they provide clients. The human side of the business is filled with people with lots of initials at the end which should give comfort that they are operating with high degree of standards to look out for their client’s best interest. The question in this case is whether the algorithms have been programmed with this in mind. As portfolios are designed and investment products are selected, are they being done with the investors best interest? Are the algorithms programmed to select securities that pay the Robo–Advisor a higher return at the expense of the client? This is an unknown and again because it is such a new business model, it will be difficult to ascertain for a while.

Skimp on education
Robo–Advisor services compared to traditional wealth management companies do appear to make a more conscious effort to educate investors about core tenants of investing. Let’s be clear here though. Their model and asset allocations are based on a passive approach which skews toward consistent. If you can’t be bothered learning about the nuances and concepts of investing, then this lack of education is of no concern. However if you are the type of person who has taken a do–it–yourself type of approach and have a high degree of investment literacy, Robo–Advisorsmay not do it for you.

Limited asset selection
The Robo–Advisor model is built around the notion of passive investment strategies and as a result, most of the asset allocation makes use of passive investment products such as ETF’s and index fund. While some companies do integrate selection of individual company stocks, they are few and far between. This is fine if the ETF’s are true baskets of stocks tracking the major indexes such as the S&P500 or the TSX/S&P Composite because those index products will track close to the indexes and charge very minimal commissions. As I have commented in the past,The ETF landscape is now changing as mutual funds and banks are getting into the mix offering more specialized ETF products that have more of an active management bent than a passive philosophy. Unfortunately they are not marketed that way. The question becomes do these automated asset allocation machines have the coding in them to separate the differences? If they don’t than investors who think they are investing in simple vanilla market matching index products could be in for a surprise.

If you are just starting out with investing, have a small amount of savings to invest, and have little to no interest to learn about investing but want to own stocks, then using a Robo–Advisor type service can be a good first step to getting in the investing game at a minimal cost. For the seasoned investors who believe in using ETF’s it can be another channel for putting money to work. For those who prefer investing in individual stocks, Robo–Advisor services in its current iteration will not be a useful channel for you. In any of these cases, you must be aware that this is a very new business model and so there is not enough data to gauge whether a computer is a more worthy advisor than bone and brains.