The Rise of the Robo-Advisor

January 11, 2018

There are three themes to the website.  I’ll state them.  Investing in markets is a positive sum game but a zero-sum game around the market return.  The ramifications are that active managers in the aggregate add negative value after-cost. The second theme is that cost matters, and matters greatly.  Everything else being equal, a 10-basis point cost factor is better than a 100-basis point cost factor and is much better than a 200-basis point cost factor.  The third theme is that financial planning and investment management is not difficult if you understand a handful of key concepts and utilize broad market, passively managed ETFs.

 

Robo-advisors are on the rise in Canada and the rest of the world.  Here is how Wikipedia defines a robo-advisor:

 

Robo-advisors or Robo-advisers are a class of financial adviser that provide financial advice or Investment management online with moderate to minimal human intervention.[1]They provide digital financial advice based on mathematical rules or algorithms. These algorithms are executed by software and thus financial advice does not require a human advisor. The software utilizes its algorithms to automatically allocate, manage and optimize clients' assets.

 

The client inputs personal and financial information into software and the software spits out a portfolio.  The robo-advisor invests in the portfolio and the firm takes a fee.  The fee is approximately 60% less expensive per year than the traditional method of investing through a financial advisor.  You won’t meet anyone from the robo-advisor’s firm, but you can communicate by email or phone with a human.  Your money will likely be invested in a basket of broad market, passively managed ETFs. The Robo-advisor will have between 5 to 15 baskets with differing proportions of growth and safety.  Each client is fit into a basket based on the information provided.  The information provided is similar to client information extracted from an asset allocation tool.

 

How do Robo-advisor firms and the three themes to the website mesh?

 

Active management underperforms passive management in the aggregate.  Robo-advisors typically, but not necessarily solely, invest client money in low cost, broad market, passively managed ETFs and shun high-cost, actively managed investment products such as mutual funds.  This is a positive and to understand why please read the Active vs. Passive Investment Management tab.

 

Cost matters and matters greatly!  Robo-advisors charge substantially lower fees than the traditional method of investing through a financial advisor.  Robo-advisors have eliminated two of the five cost centers from the financial planning process.  There is no financial advisor nor is there an active investment manager to be paid.  The robo-advisor passes most of the savings to the client.  Clients of robo-advisors have a total charge, or MER, of approximately 80 basis points, well below the 150 to 240 basis point cost working with a financial advisor.

 

Financial planning and investment management is not difficult if a few concepts are understood.  Here is where I have an issue investing through a robo-advisor.  The robo-advisor is confirmation that financial planning is not complicated.  A software program gathers your information and spits out a portfolio.  I agree.  It is that simple for most people.  Why not run your information through the myriad of free asset allocation calculators on the internet and pay the robo-advisor nothing?  Although cost is lower than traditional investment approaches, it is still 6 or 7 times more expensive per year than a do it yourself investor utilizing low cost, broad market, passively managed investment products.  This is significant.  If you can complete an asset allocation calculator, open accounts at an online broker, and research a little, why pay 65 basis points more than you need to year after year.

 

A small aspect of robo-advisors I am glad to see is that they tend to skew Canadian’s growth portfolios more towards U.S. companies.  The old rule of thumb is that growth portfolios should be invested 1/3 Canadian companies, 1/3 U.S. companies, and 1/3 rest of world companies.  Robo-advisors tend to be around 40% U.S. companies and 30% each Canadian companies and rest of world companies.  There is no denying that the U.S. is the largest, most capitalistic country on earth.  This translates to higher profit and higher expected returns.

 

A small aspect of robo-advisors I am unhappy to see is that they tend to place a small portion of Canadian’s portfolios into real estate investments.  If you are a home owner, you have more than enough exposure to real estate.  If you are a renter, it is fine.

 

Summing up, a robo-advisor is better than the traditional approach to investing through a financial advisor or planner but is still 6 to 7 times more expensive than doing it yourself.  It is not difficult to become your own financial advisor and the robo-advisors confirms this.

 

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