Robo-Advisors Threaten Financial Advisors

Robo-Advisors Threaten Financial Advisors

Ezra Zask

Robo-advisors are set to replace financial advisors in the same way that online banking is replacing bank tellers. This rapidly growing service offers many of the functions of a financial advisor, but at a fraction of the cost.  By one estimate, robo-advisors will have $2.2 trillion in assets under management by 2020.

A robo-advisor is an automated, online financial advisory service that helps manage client portfolios using computer algorithms. What is under the computerized hoods of these online services?  Despite differences, their structure is similar.  Starting with the collection of basic information on investors including their financial condition, age and risk tolerance, Robo-advisors use a variety of techniques – including pre-set model portfolios, mean-variance optimization and Monte Carlo simulation – to construct diversified portfolios that are typically populated by low-cost Exchange Traded Funds (ETFs). 

It may surprise many investors to learn that the engine used by robo-advisors to construct client portfolios is similar to that used by financial advisors.  Financial advisors collect the same information as robo-advisors and then use the same algorithms to construct “ideal” portfolios.  Both use some variation of Modern Portfolio Theory (MPT) to construct a model portfolio based on the information provided by the investor. It is therefore no surprise that the portfolios recommended by financial advisors and robo-advisors are very similar.  In fact, some robo-advisors, such as the well-known Financial Engines, started as tools that investment advisors used to develop client portfolios, and many investment advisors now use robo-advisors to help advise or manage their clients’ portfolios.

All the portfolios recommended by financial advisors or robo-advisors are variations of the 60/40 portfolio (60% in stocks and 40% in bonds).  The major asset classes are then divided into sub-classes including small cap, international, corporate bonds, etc.  The number of sub-classes in a portfolio can vary from a handful to over ten.  Some robo-advisors throw “alternative investments” such as emerging markets, real estate and commodities into the mix.

The allocation between stocks and bonds changes as the investor becomes older in a process known as “lifecycle investing.”  Older investors are more interested in assuring the safety of their investments and in generating cash flow than they are in growth.  Their portfolios are therefore skewed towards bond investments.  Similarly, investors who are risk averse will have portfolios that have a higher allocation to bonds. Younger and less risk averse investors are presented with portfolios with a higher allocation to equities.

How can investors evaluate the relative benefits of financial advisors and robo-advisors?  Part of the answer is the extent to which an investor is comfortable with using Internet-based financial services, whether on computers or mobile devices.  Millennials (born between 1980 and 2000), who are already use Internet applications to manage various aspects of their lives, are natural users of robo-advisors and are being heavily targeted by these services. 

Another consideration is the extent to which an investor is knowledgeable about investments and portfolio management in general.  While robo-advisors are designed to be easy to use, they still call for at least a basic knowledge of investments. Because a large portion of investors lack this knowledge, financial advisors will always have a role to play in providing education to less knowledgeable investors.  It is also the reason why some robo-advisors, such as Vanguard and FutureAdvisors, offer investors the option of working with dedicated investment advisors, although for an additional fee.  This also appeals to investors who miss the personal touch of a financial advisor.

Robo-advisors have a number of advantages over financial advisors.  The first is that robo-advisors typically charge lower fees.  In addition, robo-advisor fees and services are more transparent.  Finally, switching from one robo-advisor to another is a great deal easier than switching financial advisors.

With over 200 robo-advisors competing in this space, how is an investor to choose? A number of questions will help in the selection process:  What are the fees for a basic version of the robo-advisor?  These can vary from free (for example, Schwab and WiseBanyan) to close to 1% of the assets in the program.  It is also important to guage what is included in the basic service.  For example, does it include portfolio rebalancing and/or tax harvesting or are these only available for additional charges? For those looking for more highly diversified portfolios, some robo-advisors offer a greater range of asset classes than others.  Finally, robo-advisors differ in the underlying engine that drives the asset allocation, ranging from fixed templates to mean-variance optimization and Monte-Carlo simulations.

Do robo-advisors present an end to the role of financial advisors, as implied by some of the publicity that surrounds them? No. There is still an important role for financial advisors, especially in activities other than investments.  However, robo-advisors are comparable to financial advisors in some respects, but at a substantially lower cost.  With long-term interest rates under 2%, a savings of 0.25% or 0.50% is meaningful, and will assure that robo-advisors will capture a growing share of the investment advisor market. 

Summary of Human Nature and Investing

http://www.valuewalk.com/2017/07/human-nature/

Robo-Advisors and Investment Management

www.empoweredinvestors.com

Excellent Article on Big Data

https://www.ft.com/content/50bb4830-6a4c-11e6-ae5b-a7cc5dd5a28c

Will Smart Beta Replace Hedge Funds?

Will Smart Beta Replace Hedge Funds?

Issues with Hedge Fund Performance

Hedge Funds 3.0: The Continuing Evolution of Hedge Funds

Hedge Funds 3.0: The Continuing Evolution of Hedge Funds

By Ezra Zask, January 11, 2015

One of the most controversial questions in the investment world is: why do hedge funds keep gaining assets when their performance over the past decade has been relatively poor compared to stocks? After all, hedge fund returns have lagged the S&P for the past 7 years; a period that covers a full business cycle.

One way they have accomplished this feat is by changing the definition of “performance” over time to overcome the inability to live up to the preceding definition.  Thus, high return was replaced by downside protection, alpha and, most recently, diversification and risk reduction.

Hedge funds have faced a number of challenges over the past three decades that have led to fundamental changes in their objectives and operations.  A short list of these challenges includes the proliferation of hedge funds and hedge fund strategies; the institutionalization of hedge fund investors; economic crises in 1987, 1994, 1998, 2001 and 2008; and increased criticism of hedge fund performance and fees.

As with any evolution, some hedge funds thrived -- at least in terms of increasing assets under management and generating income for their managers --while others either became extinct or are an endangered species. In the course of this evolution, the surviving hedge funds would not be recognized by investors of 20 years ago.

The performance criteria that hedge funds are expected to meet has changed dramatically over the years.  We can broadly identify three hedge fund performance regimes.

In broad strokes, Hedge Fund 1.0, which was dominant in the 1980’s and 1990’s, touted the outsized return that were available through hedge fund investments.  George Soros and Julian Robertson were the models for investors.  However, as the hedge fund field became crowded, they were forced to compete in well-arbitraged markets and these outsized returns became more and more rare.  The process was accelerated by the larger scale of funds who were unable to meaningfully invest in small markets.

Hedge Fund 2.0 focused on the downside protection and absolute return measure of hedge fund performance. as indicated by their relatively small losses compared to other investments during the Asian crisis of 1998 and the Internet bubble of 2001. This hedge fund meme was exploded during the Credit Crisis in 2008 when hedge funds as a group lost over 20%.  (While still lower than the S&P loss of over 40%, the loss was not supposed to occur under hedge fund 2.0)

Hedge fund 2.0 also included the notion that hedge funds added the elusive and sought after investment alpha (returns above market returns) which ostensibly resulted from manager skill or unexploited market opportunities.  This alleged benefit was also whittled away as new sources of beta were identified (specific to hedge fund strategies and markets) and reduced the size of the alpha.

In hedge fund 3.0 performance no longer holds hedge funds to a benchmark or, indeed, any return criteria.  The performance criteria of hedge fund 3.0 is summarized in a recent paper published by the Alternative Investment Management Association (AIMA), a hedge fund industry group, and the Chartered Alternative Investment Association (CAIA), which provides certification for alternative investments. The paper is titled “Portfolio Transformers: Examining the Role of Hedge Funds and Diversifiers in an Investor Portfolio.”  Hedge funds are touted as either portfolio diversifiers or investment substitutes (for traditional stocks and bonds).  The major hedge fund strategies are placed into one of these functions:

(Source: “Portfolio Transformers: Examining the Role of Hedge Funds and Diversifiers in an Investor Portfolio.”)

The benefits for investors that result from including hedge funds in their portfolios include the following:

·        a source of diversification

·        substitutes for traditional stocks, bonds and cash investments

·        provider of downside protection

·        lowered volatility

·        possibility of improving returns in an overall investment portfolio

According to the study,

Such hedge fund strategies ought to reduce the overall volatility (i.e. reduce the risk) of the portfolio’s public markets allocation, with a more attractive risk/reward profile. Other hedge fund strategies may have a low correlation to equity and credit markets and offer a higher probability of generating out-sized returns (albeit by taking on a higher level of risk).

Employing this approach (where hedge funds take on the role of a substitute or complement the equity or fixed income portfolio) offers the plan a way of reducing the volatility (risk) within their public equity allocation, with little if any reduction in the portfolio’s total performance.

One of the interesting aspects of Hedge Funds 3.0 is that performance in terms of beating a benchmark (whether S&P or any other benchmark) is no longer required for a hedge fund to be successful.  The most that is held out to investors is that hedge funds “offer a higher probability of generating-outsized returns (albeit by taking on a higher level or risk,” which is a tautology that is true of any risky investment.)  The second crumb offered to investors is that diversification via hedge funds results in “little if any reduction in the portfolio’s total performance.”

Both of these measures of “success” may come back to haunt hedge funds because it places them squarely in competition with other “substitutes” and “diversifiers” such as smart beta, commodities, and index funds.

Ezra Zask is a 25-year veteran of the hedge fund and investment industries.  He is President of Ezra Zask Research Associates, an alternative investment consulting firm.  He is also the author of All About Hedge Funds, Second Edition (McGraw Hill: 2013)