Robo-advisors Are They Really 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 that is a very loose set of heuristics and ideas, along with some technical flim-flammery. 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 that you don’t understand is just as bad as handing it to a Human Advisor who has little or no talent in investing. A task badly done by technology or a human is still a task badly done.
An important thing to remember is the Robo-advisor simply does what it is programmed to do, it “decides” on the basis of 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 is going to 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 3 months, compare holdings percentages and if any position is greater than 5% off 25% (plus or minus) rebalance using existing funds.
This pretty much 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 being seen in the market place already.
- 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 simplistic 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 kind (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