Robo-advisors have yet to be tested

The latest competitor in investment management is the online portfolio manager – colloquially known as a robo-advisor. These platforms build a portfolio of exchange-traded funds (ETFs) for investors on the basis of a short questionnaire.

While convenient and low-cost there are problems with relying on this technology. 

Designed for investors with a small amount of investable assets, robo-advisors aim to reduce costs by keeping service and staff levels low. These platforms further mitigate costs by outsourcing investment management via the use of ETFs.

The robo-advisor’s simplicity is appealing. You answer a questionnaire then your portfolio is built. For a novice investor during a stretch of market gains in the U.S. and Canada the passive robo-strategy is sound.

But what happens when the market corrects?

In order to track their respective indexes, index-following ETFs need to hold a proportionate amount of the largest constituents.

With this in mind, Canadian investors should question if they really want to put most of their money into the largest and most expensive companies in the domestic index:

Source: Thomson ONE

As an experiment to test the system, I answered the questionnaires and built mock portfolios using three robo-advisors.

A bank-owned one asked ten questions, all pertaining to my investment objectives and nothing about my personal circumstance. Then it spat out a portfolio of proprietary products.

The two independent platforms were better. Both asked about my personal situation and attitude towards investment. They also provided the individual ETF constituents in my selected portfolio. I liked the depiction of risk of the available portfolios from the second independent:

Source: Leading independent online portfolio manager

But how prepared are clients to actually handle this kind of downside? And while these services provide access to a person to talk with, it’s not someone you trust. When a position corrects 15.6% that’s one thing but if an entire portfolio goes through this, clients expect answers and fast.

If the trusted human advisor describes something along the lines of what happened in 2008/09 and the client holds on and adds to diminished positions, they would be handsomely rewarded. The person invested with the robo-advisor would be discouraged and likely unwilling to re-enter the market at an opportune time.

This is the problem with how the public perceives what an advisor is. An advisor should be a coach who knows you rather than someone who just picks stocks. David Chilton, author of The Wealthy Barber calls robo-advisors ‘robo-asset allocators’ because that’s all they do. As was verified for me in the bank robo-advisor questionnaire there’s no question as to whether I hold a $600,000 mortgage or have $10,000 in credit card debt. If I did, it would not be wise to aggressively invest in a US small-cap ETF.

The robo-approach is highly automated giving them some advantages in administration of accounts but their ability to truly know their clients is limited. This ultimately puts clients at risk because all of their needs are not being met.

Will the robo-advisors survive? We’ll learn more after they experience their first market correction.

 

Fraser Betkowski

 

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Fraser, The MacBeth Group team and their clients may trade in securities mentioned in this blog.

 

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