Robo Advisors: A personal experience - Part 2: The Reveal

In my first post in this series I described the process I went through to setup a portfolio with a Robo-Advisor service (ROBO).  I contributed $5,000 to meet the minimum investment required and the account was setup. Two business days after, the money was invested according to the asset allocation weightings  the ROBO created based on my responses to questions about my risk tolerances.

Below to recap is my portfolio along with portfolio weightings allocated by my ROBO:

Dividend Stocks 15%

Risk Managed Bonds 15%

Foreign Stocks 15%

US Stocks 15%

Canadian Stocks  10%

Risk Managed Equities 10%

Real Estate Stocks 10%

Emerging Markets 10%

 

The ROBO calculated my risk score to be 9, which is high.  According to ROBO,

“You seek a portfolio that provides long term growth. Your assets are invested primarily in equities. You accept a high degree of market fluctuation, with the goal of achieving superior long term returns. You accept that there will be times of negative performance.”

I think that’s about right. I’ve been investing for almost 20 years now and have a much greater tolerance for market fluctuations and managing those risks from a tactical and behavioral perspective.  Thank you Malcolm Gladwell.

Immediate First Impressions

At first glance, I was quite surprised to see the large number of asset allocations. I thought I would see just a handful of ETF’s. I also was surprised to see more specialized, tactical type ETF’s instead of using generic vanilla ETF’s that invest in a broad index. It is a bit of flag for me in that these tactical type of funds would skew toward active investing that churns stocks. We'll see as I open the hood on these investments and I’ll be watching that closely in the future  Many Robo Services sing the praises of passive, hands-off investing as performing well versus active managed mutual funds. The allocation of this ROBO makes me at first blush wonder if this will be the case.

So let's open the hood and see what ROBO has done for me:

 

Dividend Stocks (Portfolio Weighting 15%)

ROBO Goal: Ownership in global companies that have a history of increasing dividend payouts. They tend to be large household names, and are less volatile than the broad market. In the current low interest rate environment, they represent an attractive alternative to bonds.

ETF Used: Purpose Core Dividend Fund (PDF), MER 0.66%

The PDF represents a type of ETF called a corporate class fund (CCF). The Canadian Couch Potato ETF site classifies CCF’s as:

"...Corporate class mutual funds are not trusts: they’re corporations. A single corporation is set up to hold several funds, each structured as a different share class. For example, a single mutual fund corporation might include a Canadian equity fund, the US equity fund and a bond fund. If you switch between an equity fund and the bond fund—while rebalancing your portfolio, for example—no actual sale has taken place. This allows an investor to defer capital gains until the shares are eventually sold. Unlike trusts, corporate class funds can’t pass along all their income to shareholders, so they also tend to have fewer taxable distributions..."

"...To use an analogy, think of mutual fund trusts as individual houses. In order to move, you need to sell one house and buy another. Corporate class funds are more like a single house with several rooms: you can move from one room to the other without selling anything..."

Got it? Clear as mud?

The Purpose Core Dividend fund is one component of a family of funds managed by Purpose Investments.

According to Purpose, "The fund invests in an equally weighted portfolio of approximately 40 high quality North American dividend-paying equity securities based on a fundamental rules-based portfolio selection strategy that intends to create value and reduce risk over the investment period."

I’d sure like to know what that selection strategy involves. The average daily volume is about 19,000 shares which isn’t horrible but it isn’t that great either. The more vanilla ETF products like Vanguard and iShares have greater volumes. The portfolio has about an even distribution between US and global stocks. Utilities are the biggest sector component at 16.7% with other sectors like financials, consumer staples, energy, and communication services evenly distributed. I like this as most dividend ETF’s are quite top heavy in financials.  The 0.66% MER is rather high. There really isn’t any performance history, so I’m curious why ROBO thinks this ETF is better than other more proven products out there.

 

Risk Managed Bonds (Portfolio Weighting 15%)

ROBO Goal: Debt issued by North American companies and governments to fund activities. Uses a risk management strategy to reduce the risk of interest rate swings.

ETF Used: Purpose Total Return Bond Fund (PBD) MER 0.96%

According to Purpose, "The Purpose Total Return Bond Fund seeks to achieve a positive total return in diverse market environments over time by tactically allocating its assets among a broad range of fixed income securities, including government debt, investment grade corporate debt and high yield debt."

The word that jumps out is “tactically allocating its assets”. Passive portfolios don’t tactically allocate. They just invest in a basket of securities that mirrors a broad based index. When tactics are involved, isn’t that active investing?

When I looked at the holdings I was surprised to see that the portfolio comprised of …more ETF’s, specifically a family of BMO ETF’s comprising of the BMO Mid Corporate Bond ETF, the BMO High Yield US Corporate Bond ETF (C$ Hedged), and the BMO Mid Federal Bond ETF. 64.7% of the Purpose ETF is invested in this BMO Mid Corporate Bond ETF. 64%! My question to the ROBO is why didn’t “it” (remember it’s a computer doing this right?) just invest in the BMO ETF’s directly? The MER’s are much lower (0.34% for the Mid Corporate ETF for example). Doesn’t make sense.

So essentially the Purpose Bond ETF is an ETF of ETF’s, much in the same model as hedge funds with their Fund of Funds models. Now I get why the MER is 0.96%.

 

Foreign Stocks (Portfolio Weighting 15%)

ROBO Goal: Ownership share in companies based in Europe, Australia, and Asia. Historically, underperformed US stocks but reduces risk through diversification.

ETF Used: iShares Core MSCI EAFE ETF (IEFA) MER 0.13%

The investment seeks to track the investment results of an index composed of large-, mid- and small-capitalization developed market equities, excluding the U.S. and Canada. The fund generally invests at least 80% of its assets in securities of the underlying index and in depositary receipts representing securities of the underlying index. The underlying index is designed to measure large-, mid- and small-capitalization equity market performance and includes stocks from Europe, Australasia and the Far East.

I found it interesting again that ROBO chose to invest in the US$ version of the iShares ETF. There are similar Canadian iShares products. For example, the iShares Core MSCI EAFE Index ETF (Ticker: XEF) is a currency unhedged ETF that carries an expense ratio of 0.20% versus the 0.13 for the US version along with the iShares MSCI EAFE Index ETF that is currency hedged.  A good point about the IEFA is that the trading volumes are much higher with average daily volume over 900K shares/day. Overall it seems like a reasonable allocation and solution.

 

 US Stocks (Portfolio Weighting 15%)

ROBO Goal: Ownership share in US-based companies. Historically, the major driver of long-term portfolio returns.

ETF Used: Vanguard US Total Market Index ETF (VTI) MER 0.03%

The investment seeks to track the performance of a benchmark index that measures the investment return of the overall stock market. The fund employs an indexing investment approach designed to track the performance of the CRSP U.S. Total Market Index, which represents approximately 100% of the investable U.S. stock market and includes large-, mid-, small-, and micro-cap stocks regularly traded on the New York Stock Exchange and Nasdaq. It invests by sampling the index, meaning that it holds a broadly diversified collection of securities that, in the aggregate, approximates the full index in terms of key characteristics.

ROBO decided to go with one of the most vanilla ETF’s out there in the Vanguard US Total Market. When you buy VTI you pretty much get exposure to the entire US stock market universe, not just the big names. The ETF has an MER of a microscopic 0.03%. Again interesting that ROBO went with the US$ denominated version instead of the Canadian version.

Canadian Stocks (Portfolio Weighting 10%)

ROBO Goal: Ownership share in companies based in Canada. Often over-represented in Canadians' portfolios, but a major part of long-term returns.

ETF Used: iShares Capped Composite TSX Index (XIC) MER 0.05%

The investment seeks to replicate the performance, net of expenses, of the S&P/TSX Capped Composite Index. The index is comprised of the largest (by market capitalization) and most liquid securities listed on the TSX, selected by S&P using its industrial classifications and guidelines for evaluating issuer capitalization, liquidity and fundamentals.

Another go-to vanilla ETF, the XIC provides exposure to the S&P/TSX Composite which skews heavy into Canadian financials and commodity stocks. One of the bad habits Canadians get into is holding way more Canadian companies than foreign companies. The Canadian stock market represents only 6 percent of the global market so it is postitive to see ROBO allocating a  smaller weighting to Canadian stocks. It’s sad to say that in terms of investing opportunities, there are way way more of them outside Canada.

Risk Managed Stocks (Portfolio Weighting 10%)

ROBO Goal: Ownership share in US-based companies. Uses a momentum-based strategy designed to protect investors against big market downturns. Performed very well in 2008 market crash.

ETF Used: Purpose Tactical Hedged (PHE.B) MER 0.90%

The fund seeks to provide shareholders with (i) consistent long-term capital appreciation with an attractive risk-adjusted rate of return investing in a portfolio of North American equities; and (ii) provide less volatility and low correlation to North American equity markets by hedging the fund’s exposure to overall market risk.

This is definitely not a passive oriented ETF. When you’re trying to make investments that allocate funds to smooth out volatility and minimizing correlation, you probably need a few ROBO advisors and you’re going to pay for it as the MER comes in at 0.90%. What’s that about ETF’s being cheap? The ETF invests primarily in US stocks but isn’t the VTI Vanguard US ETF which invests in pretty much the whole US stock market take care of our exposure? So why add another US oriented ETF (a costly one at that) that is likely duplicate some of the Vanguard exposure? In terms of trading volume, PHE.B trades about 7,700 shares a day implying the asset prices are going to be more volatile. According to their mission, the objective is to “provide less volatility and low correlation..” Seems contradictory.  Adding the Purpose ETF, our portfolio is now 25% exposed to the US stock market (we're still not done yet), a market many including yours truly feel is overvalued.

Real Estate (Portfolio Weighting 10%)

ROBO Goal: North American real estate companies. Acts partly like stocks (capital returns) and partly like bonds (generates cash flow) and also protects against inflation.

ETF Used: Purpose Duration Hedged  Real Estate Fund (PHR) MER 0.65%

The investment seeks to (i) provide shareholders with long-term capital appreciation by investing in a portfolio of real estate focused equity securities listed on major North American exchanges and (ii) reduce the risk of rising interest rates associated with real estate equity securities by tactically hedging the duration of the portfolio. The fund will use a multi-factor, fundamental rules-based portfolio selection strategy to select securities from a universe of North American listed equity securities in the real estate sector. The selection strategy will emphasize factors that have shown to be effective at differentiating between strong and weak performing real estate companies including: fundamental change, valuation, growth and quality.

Look at that! Another Purpose ETF. Remember this company has been around for only a couple of years so the performance history is well…it doesn’t have any! These ETF’s haven’t been exposed to a full bull/bear market cycle. Yet our ROBO has crunched the numbers and believes this is the optimal solution for my portfolio. I’ll yield to ROBO’s assessment. It’s what I signed up for. 

If it isn’t clear by now, it should be. I’ve come to the conclusion that Purpose ETF’s are not straight vanilla ETF’s. Clearly they are adopting active management strategies. This ETF charges 0.65%, another very high cost to pay compared to other passive REIT ETF’s which I suspect could get you a similar exposure at a lower cost. 51 percent of the ETF is invested in US equities with the remaining in Canada. Again it is likely that the Vanguard VTI ETF will own some of these companies in the Purpose ETF. Just doing some number scratching, it looks like my US exposure is now at least over 30 percent with my Canadian equity exposure closer to 15 percent. The ETF trades on average 286 shares/daily. 286 shares daily!!! That' is practically nothing nothing. There is very little liquidity in this ETF which is quite concerning.

  

Emerging Market Stocks (Portfolio Weighting 10%)

ROBO Goal: Ownership share in companies based in emerging economies like China, Brazil, Russia, and India. Reduces the portfolio's risk through diversification and adds the possibility of higher returns.

ETF Used: iShares Core MSCI Emerging Markets (IEMG) MER 0.18%

The investment seeks to track the investment results of the MSCI Emerging Markets Investable Market Index. The underlying index is designed to measure large-, mid- and small-cap equity market performance in the global emerging markets. The fund generally invests at least 80% of its assets in securities of the underlying index and in depositary receipts representing securities of the underlying index.

Again ROBO has chosen to go with a US$, unhedged ETF. It is much more passive compared to the Purpose ETF’s. It has a very portfolio friendly MER of 0.18%. It covers a broad cross section of developing economies.

 

There it is ladies and gentlemen my ROBO portfolio!

 

OTHER ActivitIES OF NOTE

  • When setting up the portfolio the ROBO initiated a transaction to convert a portion of the portfolio into US$ so it could purchase more effeciently. In my case they converted $1830CDN to 1453 (1US$ = 1.259CDN)
  • It’s interesting that they purchased the foreign ETF's in US$ so now my portfolio has currency exposure with no hedging. There are different schools of thought on whether it is worth hedging currency risk. One side says that over the long term, things even out. The question is what is long term and am I willing to wait that long for an adjustment?
  • After the initial investments were made, ROBO decided to purchase additional units of PBD and PHR to rebalance the allocation to their allotments levels. So it appears the ROBO doesn’t waste time when it comes to rebalancing activities.

Overall Observations

I think because my risk score was very high, ROBO concluded that I would be comfortable with a more aggressive investment strategy. High risk however should not automatically mean invest in complex assets. It can also mean allocating higher weightings to core positions. I would be curious to see what would have happened to my portfolio  if my risk tolerance was lower. Would ROBO still invest in some of these tactical type ETF funds at all or just place a lower weighting?

In terms of ETF’s selected, I get the feeling I just became a customer of Purpose Investments with half the portfolio invested in their product line.

It is interesting that while almost 60 percent of the portfolio is invested in foreign ETF’s, none of it is currency hedged. It appears my ROBO doesn’t believe in hedging. ROBO appears to be dependent on empirical research and there is a fair bit that says currency hedging doesn’t work and that over long term, currency fluctuations will smooth themselves out. It’s no big deal right now as the US$ has been on a tear over the last year, so I wouldn’t be surprised to see the returns a bit inflated. If the US$ should stabilize or weaken then it will be interesting to see how ROBO reacts.

I think using the Purpose funds seem like overkill as their funds appear to overlap with the iShares and Vanguard vanilla ETF’s. I wonder if just going with the 4 generic ETF’s at higher weightings would be simpler, cheaper, and easier to manage? 

The total Management Expense Ratio for this portfolio is 0.45% which is reasonable, however this represents only the MER for the ETF's themselves. When you add the 0.50% cut that ROBO takes to cover trading costs and their own margin, we're now looking at an overall cost of the ROBO portfolio of 0.95%. One percent cost seems somewhat reasonable and is a lot cheaper than what mutual funds charge. Could this be done cheaper on my own? Probably but I could see how this could appeal to people who just couldn't be bothered to micro-manage their portfolio and would prefer to outsource it. The question is whether there is enough performance behind it to justify the cost. 

Again the point of this exercise is that I am not managing this portfolio. I’ve decided to outsource this small portion of my savings. So I need to suck it up, sing that Frozen song my kid keeps singing and watch how this unfolds. I also realize to judge to effectiveness of this portfolio at the onset is not fair. We have to give it time but as we travel, I hope we get to learn together a lot more about the intracacies of the Robo Advisor investment model.