Fund Spotlight

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Emerging market stocks were battered in 2022. Many emerging market funds reached highs in February 2021, about the same time cryptocurrencies and speculative technology funds such as ARK Innovation (ARKK) were peaking. Unlike speculative growth stocks, most emerging market funds, including Fidelity Emerging Markets (FEMKX), have gained little on an annualized basis since 2007. Fidelity Hong Kong and China (FHKCX) has risen about 30 percent in 15 years, an annualized return of about 1.8 percent.

Weakness in emerging markets stems from several factors. First, the 2008 financial crisis wasn’t only about the U.S. housing market and the related financial assets. It was also the peak of a commodities bull market. China was the main driver of commodity demand. Its economy started slowing significantly in the 2010s and has continued slowing with a policy of lockdowns for the coronavirus. Many developing countries export commodities to China, making a slowdown bad news for the entire asset class. China also dominates many emerging market funds.

From the perspective of bullish investors, emerging markets are undervalued. The index funds such as MSCI Emerging Markets trade near a forward P/E of 10 that marked the low for most of the past 15 years. Only the lows in 2008 pierced that level. With many country funds flat since the 1990s or 2000s, they are much cheaper than they’ve been in years. Cycles are also lining up in their favor. The late 1990s and early 2000s also saw a strong U.S. dollar, a bottom in commodities such as oil and a bear market in technology stocks.

The biggest risk for emerging markets in the near term is currency risk. The Chinese yuan is overvalued and can probably fall another 10 percent. This seems highly likely if currencies such as the yen, euro and Korean won resume their weakness. Emerging market currencies will likely underperform the Chinese currency, perhaps moving lower by 15 percent to 20 percent.

Over the next 12 months or so, currency risk is highly relevant for investors. A surge in the U.S. dollar could force emerging markets lower and provide a major low that won’t be seen again for a decade or longer. In the longer term, valuations will be more important. Emerging markets have underperformed uninterrupted for almost 12 years. The longest stretch of outperformance was a two-year run from the market low in January 2016 until early 2018. Going back to the relative performance peak in 2010, FHKCX and FEMKX have risen 52.67 percent and 31.59 percent, respectively, versus the 330.02 percent rally in SPDR S&P 500 (SPY).

Looking forward, emerging markets may provide aggressive investors a solid value opportunity.

Fidelity Emerging Markets (FEMKX)

FEMKX seeks capital appreciation from superior asset selection. Emerging markets are more complex investments because there are currency and economic risks that differ from those in U.S. markets. The fund seeks strong, stable companies that are undervalued by the market.

FEMKX has been managed by John Dance since February 2019. He previously managed Pacific Basin (FPBFX) and Emerging Asia (FSEAX) before leading this fund. Under his tenure, FEMKX gained more from Chinese technology exposure than it has given back, making for outperformance over his thus far brief tenure.

The fund has an expense ratio of 0.88 percent and a turnover rate of 36 percent, plus 5-star and Bronze ratings from Morningstar.

Portfolio

The portfolio leans toward higher-quality, large-cap stocks as compared with the category and plain vanilla passive emerging market indexes. China makes up 28 percent of assets, India 19 percent, Taiwan 12 percent, Saudi Arabia 5 percent and South Korea 5 percent. The largest currency exposures are the Indian rupee at 19 percent, Hong Kong dollar 17 percent, U.S. dollar 16 percent, Taiwan dollar 12 percent and Chinese yuan 8 percent.

The top holdings have been Taiwan Semiconductor at 7.82 percent, Tencent 5.59 percent, Samsung 3.76 percent, Reliance Industries 3.29 percent and Kweichow Moutai 2.99 percent.

FEMKX has a beta of 0.92 versus 0.98 for the category and 0.95 for the emerging markets index. It has a standard deviation of 19.41 percent versus the 20.53 percent of the category and the 19.21 percent of the index. Lower volatility comes from the larger average market capitalization in the fund.

Fidelity Hong Kong and China Region (FHKCX)

FHKCX has been managed by Ivan Xie since April 2018 and co-manager Peifang Sun since January 2021. Both previously worked as analysts covering the Greater China region. The fund mainly searches for growth at a reasonable price along with turnaround plays in cyclically depressed industries.

The expense ratio is 0.91 percent. Turnover is 60 percent. FHKCX has a 4-star and Neutral rating from Morningstar.

Portfolio

Like FEMKX, this fund has a higher average market cap than the China category and the China index. Technology leads with 24 percent of assets, followed by consumer discretionary with 24 percent, financials 16 percent, communication services 10 percent and consumer staples 5 percent. Geographically, China leads with 62 percent of assets. Taiwan has 23 percent and Hong Kong 9 percent.

There is some overlap with FEMKX in the top holdings. Taiwan Semiconductor has 16.38 percent of assets, Tencent 8.29 percent, Alibaba 5.82 percent, AIA Group 5.11 percent, Meituan 4.51 percent, Industrial & Commercial Bank of China 2.82 percent, China Construction Bank 2.54 percent, Pinduoduo 2.42 percent, Kweichow Moutai 2.04 percent and Media Tek 1.92 percent.

FEMKX has a beta of 0.70 versus 0.61 for the China category and 0.53 for the MSCI ACWI ex-USA Index. The standard deviation is 20.77, below the 23.57 of the China category and higher than the 20.44 of the MSCI ACWI ex-USA Index. The lower volatility and correlation as compared with the category are explained in large part by its larger market capitalization, while the higher beta and standard deviation versus the index are explained by the country concentration.

Outlook

Emerging market indexes have gone nowhere since 2007. Chinese indexes are also below levels seen in 2007. The long stretch of underperformance was a combination of cyclical factors such as the commodities cycle, the currency cycles favoring the U.S. dollar, excessive optimism in the 2000s giving way to the reality of slower Chinese growth in the 2010s, and now high volatility in the wake of the coronavirus pandemic, deglobalization, trade tensions and rising geopolitical risk.

Valuations have largely priced in these risks, and the remaining risk will stem from currencies and China’s coronavirus policy. Currency risk will follow the U.S. dollar. If its rapid rise continues, volatility in the currency markets will intensify. If emerging markets are forced into significant devaluations, that will be the absolute best time to buy. For this reason, we would not go “all-in” on emerging markets here, but instead, start small and build on weakness moving forward.

China will also be key for emerging markets. FHKCX is a much riskier fund because it is concentrated in China, but investors who want emerging markets exposure won’t see good returns until the Greater China region moves higher. The risk in China is political, plus it has the same currency risk as elsewhere. The government is still shutting down entire cities as part of its zero-COVID strategy. This has greatly slowed the economy. China analysts who don’t trust the government data believe the country could already be on the brink of a recession.

Investors love to say they’re contrarian, but real contrarian investing comes from buying when nobody else wants the assets. We still see potential risk in emerging markets that should keep conservative investors on the sidelines for now, but younger investors with long time horizons can start building a small starter position if they’re planning on holding for five or more years. Conservative investors would be better served by patience. That could mean missing some of the gains if a low is already in, but it avoids potential double-digit losses if there is one more downswing for these markets.

We recommend avoiding FHKCX. China will have more upside potential at the low, but until it reopens, risk is elevated. FHKCX has outperformed, but it still lost 16 percent from high to low in October versus 24 percent for iShares China Large Cap (FXI). The accelerating decline in Chinese shares looks like the type of drop that precedes a major low, but conservative investors should be wary of catching the proverbial falling knife.

Consumer discretionary exchange-traded funds (ETFs) offer investors low-cost exposure to companies such as luxury goods retailers, fast food restaurants, and home improvement stores that rely on optional consumer spending. The consumer discretionary sector has a history of outperforming the market during the early stages of business cycles. It underperforms as the cycle matures and during recessions. In December 2016, the University of Michigan consumer sentiment survey reached its highest level in 10 years due to postelection optimism. Recent labor and unemployment reports reflect a strong job market, which also contributes to consumer confidence and additional spending. The five-star Morningstar-rated iShares U.S. Consumer Services ETF (IYC) and the four-star-rated Consumer Discretionary Select Sectors SPDR (XLY) and Vanguard Consumer Discretionary (VCR) ETFs are three reasonable options for investors seeking consumer discretionary sector exposure.

Fund Investment Strategies

With $812 million in assets under management (AUM), IYC is the smallest of the three funds. It uses a market capitalization–weighted exposure to domestically domiciled companies that primarily depend on discretionary consumer spending. The fund seeks to track the highly diverse Dow Jones U.S. Consumer Services Index, which contains 185 individual names. Managers will invest 90 percent of assets in securities and depository receipts representing the stocks contained within the underlying benchmark. With a 77 percent exposure, the index is weighted toward giant- and large-cap high-quality names. There is also an 18.3 percent exposure to mid-cap shares.

Following a full replication strategy, XLY attempts to track the 13 percent of companies that compose the consumer discretionary sector of the broader S&P 500 Index. Individual stocks are included in the portfolio based on the assignment rules for the S&P 500 and are added or removed from the ETF when the index is reconstituted. With slightly more than $12 billion in AUM, XLY is the largest of the funds. It is heavily weighted toward quality names.

The passively managed VCR also uses a full replication strategy as it seeks to track the returns of the benchmark MSCI US Investable Market Consumer Discretionary Index, an index composed of variably sized U.S. companies. Fund managers invest substantially all AUM in stocks contained within the index. The $2.1 billion fund holds stocks in the same weighting as the underlying benchmark.

Fund Similarities and Differences

IYC has a 98.77 percent exposure to domestic shares and a 1.1 percent allocation to stocks in Developed Europe. Its cash position is negligible. IYC is underweight consumer cyclical shares and slightly overweight the industrial, consumer defensive and healthcare sectors when compared with its benchmark. The fund has a price/earnings (P/E) ratio of 20.31 and a price-to-book of 3.95.

XLY has a greater than 99 percent exposure to domestic stocks. Fund managers hold consumer cyclical, communications services, and consumer defensive shares in the same weighting as its benchmark. In addition to a price-to-book of 4.21, XLY has a 19.3 P/E ratio.

With more than 97 percent of AUM allocated to domestic shares, VCR holds a small 1.5 percent exposure to international stocks domiciled in Greater Europe. The remainder is held in cash. The fund holds consumer cyclical, communication services, and consumer defensive stocks in the same weighting as its benchmark. VCR has a P/E ratio of 18.82 and a price-to-book of 4.3.

All three funds’ holdings overlap significantly. XLY shares 71 percent of its holdings with IYC. While IYC concentrates 44 percent of AUM in its top 10 holdings, VCR has a 42 percent concentration. XLY allocates 54 percent of its assets to largest 10 positions. The top 10 common holdings in all three funds include Amazon (AMZN), Comcast (CMCSA), Home Depot (HD), Walt Disney (DIS), McDonald’s (MCD), Starbucks (SBUX), and Priceline (PCLN). While IYC invests in Wal-Mart (WMT), CVS (CVS), and Costco (COST), XLY has Nike (NIKE), Time Warner (TWX), and Charter Communications (CHTR). VCR also holds Nike and Time Warner, as well as Lowes (LOW). While media firms constitute 26 percent of XLY and 23.7 percent of IYC, they are only 14 percent of VCR.

Although most of the funds’ holdings are U.S.-based, many have significant overseas operations, which increases exposure to lingering macroeconomic factors in Europe and China. With approximately 200 more individual holdings than IYC, VCR’s extra holdings represent only 5.1 percent of AUM.

Historical Performances, Risks, and Fees

XLY has the high Morningstar return rating, while IYC and VCR ETFs garner above-average ratings. XLY has the highest 12-month yield at 1.64 percent, followed by VCR’s 1.54 percent and IYC’s 1.06 percent.

Fund Returns	1-Year	3-Year	5-Year
Consumer Discretionary Select Sectors SPDR (XLY)	27.22	11.90	16.92
iShares U.S. Consumer Services (IYC)	24.89	11.35	16.83
Vanguard Consumer Discretionary (VCR)	28.63	10.79	16.29

 

Morningstar Category Average Returns

23.90

6.94

12.86

XLY has an average risk rating, a three-year beta of 1.01, and a 12.62 standard deviation. VCR also has an average risk rating and features a 1.01 beta and a 12.56 standard deviation. Earning a below-average risk rating, IYC has a 0.93 beta and an 11.76 standard deviation over the same period. The category three-year beta and standard deviation averages are 0.95 and 13.3, respectively. IYC keeps volatility lower by holding some nondiscretionary retailers within its portfolio.

With a 0.44 percent expense ratio, IYC charges substantially more than many of its competitors. It has also lagged its benchmark by 48 basis points since its June 2000 inception. In comparison, VCR has a 0.1 percent expense ratio, the second lowest of any large consumer discretionary ETF. This ETF trailed its benchmark by just eight basis points in 2016. Lagging its benchmark by 18 basis points, XLY charges a slightly higher 0.14 percent expense ratio.

Suitability and Recommendations

The consumer discretionary sector is generally more volatile than the broader market. Because of their narrow focus, greater volatility, and high sector concentration, these ETFs are a suitable satellite holding of a well-diversified portfolio when employment rates, income, and consumer confidence are on the rise.

Although these three funds are very similar, they do differentiate themselves. IYC has the lowest correlation and lowest volatility of the three, and it did hold up best during the financial collapse of 2008. However, it also offers the lowest yield and has the highest expense ratio. The high cost can drag on returns over the long term.

VCR has the broadest portfolio, lowest expenses, and lowest tracking error, and a solid yield. VCR historically performs best during the most bullish of years, when its small- and mid-cap exposures deliver an upside kick. An investor confident in the consumer discretionary sector as well as the overall stock market should gravitate toward VCR.

As the lowest-cost fund, XLY has the highest yield and heavy large-cap exposure. Even after adjusting for assets and share price, XLY’s trading volume is about 10 times that of VCR, as the latter attracts long-term buy-and-hold investors.

We have currently issued Buy recommendations for XLY and IYC, with rankings of 90 and 88, respectively. Both are solid alternatives. Given the positive outlook for the remainder of 2017, our choice is VCR, which we have upgraded to a Strong Buy recommendation with a ranking of 93. This fund should outperform its competitors on a relative basis, while charging a lower fee.

For investors who do not utilize professional management, research has confirmed that the average investor is better served by using passive mutual funds and ETFs. If investors have no interest in making changes, even quarterly or semiannually, they have a greater probability of success if they simply invest their money in a low-cost index.

Actively managed funds generally have a defined objective, and they may underperform when their mandate is not currently successful in the market. For example, the management of Vanguard Health Care (VGHCX) has had excellent historical performance, and dramatically outperformed the market indexes, earning a 4-star rating from Morningstar. However, in 2016, the fund underperformed both the S&P 500 and the Dow Jones Industrial Average. As it is an actively managed fund, with a specific investment requirement, it’s no surprise that it would underperform the broader market when the healthcare sector is lagging.

A position like this may make sense when your portfolio is being diligently monitored. With active management or dedicated attention to the holdings of actively managed mutual funds, an investor can perform significantly better the broader market. Funds with a specific focus or identifiable philosophy can be bought and sold as the market dictates. Nevertheless, if investors are not reviewing their holdings, investing in targeted funds can hamper returns. Passive strategies that invest in index funds over the long term can be a better option for such investors.

Strategies benchmarked to broad market indexes can provide stable risk-adjusted returns relative to the broader market. Index funds also provide greater diversification as they generally hold a broad range of securities, limiting stock-specific risk. They also have a tax advantage because they distribute capital gains less often and are typically meant to be held over the long term, providing lower portfolio turnover that reduces trading expenses.

This low-cost strategy provides an option for investing in a broadly diversified portfolio benchmarked against a wide variety of market indexes than can actively managed funds, though it may sacrifice greater gains.

Investors seeking a diversified portfolio in a single fund should consider the large-blend category Vanguard 500 Index Fund (VFINX) as a core holding. Established in 1976, VFINX was introduced as the industry’s first passive index mutual fund for individual investors. It provides a low-cost way to achieve a diversified exposure to the domestic equity market. The fund invests in the 500 largest companies in the country, which represent a cross section of industries and sectors, striving to replicate the return of the S&P 500 Index.

Investment Strategy

Led by Donald Butler and Scott Geiger, fund managers use a full replication strategy to track the underlying index, which promotes diversification, lowers risk and fosters low turnover. Because of its conservative eligibility requirements, the index has a tilt toward higher-quality names. The fund’s average market cap weighting approach pulls the portfolio toward giant- and large-cap stocks. This weighting approach, which is like that of its large-blend category peers, is beneficial during bull markets when larger-cap names are providing leadership. The fund invests substantially all its assets in stocks contained within the index, holding each stock with approximately the same weighting found within the benchmark. The low fees and diverse, well-constructed portfolio should enable the fund to continue its history of superior risk-adjusted returns.

Portfolio Construction and Holdings

The large core fund has $26.7 billion in AUM, with 98.79 percent allocated to medium-, large- and giant-cap stocks. The fund has minimal exposure to small-cap shares. Its average market cap of $80 billion is higher than the $61 billion average of the benchmark. The mutual fund’s P/E ratio of 18.51 and price-to-book ratio of 1.93 are in line with those of its benchmark and category. When compared with the underlying index, the fund is slightly overweight consumer defensive, energy, technology and healthcare shares, while being marginally underweight basic materials, real estate and industrial names. The top 10 holdings represent 19.1 percent of AUM. They include Apple, Microsoft, Alphabet, Exxon Mobil and Johnson & Johnson. The next five largest holdings, in declining order, are Berkshire Hathaway, JPMorgan Chase, Amazon, General Electric and Facebook.

Historical Performance, Fees and Expenses

The fund’s investment strategy, sector weightings and low turnover have enabled it to return an average of 6.87 percent per year for the 10-year period. However, it performed slightly worse than the 6.99 percent return of the S&P 500 over the same period, due in part to the management expense. The low 0.16 percent turnover rate lessens the likelihood of taxable capital gains distributions. This rate is approximately 80 percent less than the category average. Another benefit to investors is the fund’s 0.05 percent expense ratio, which is low compared with the category average of 0.79 percent.

For the past three-, five- and 10-year periods, VFINX has earned above-average return ratings from Morningstar. The fund’s one-, three- and five-year returns of 20.00, 10.71 and 13.73 percent, respectively, are slightly higher than the average of the category. With a three-year beta and standard deviation of 1.00 and 10.46, matching the underlying benchmark, VFINX earns an average Morningstar risk rating. Over the past 10 years, the fund has shown excellent tax efficiency and a minimal tracking error.

VFINX has a minimum initial investment of $3,000. It is also available as Admiral Shares using the ticker symbol VFAIX. Although it requires a higher initial investment of $10,000, VFAIX has an even lower expense ratio of 0.05 percent. Investors interested in this fund may also consider Vanguard’s S&P 500 ETF. Trading under the symbol VOO, it also has an expense ratio of 0.05 percent, which is 95 percent lower than the category average.

Recommendation

For investors seeking a large-cap, low-cost investment option, VFINX is an excellent solution. It provides diverse exposure to a broad range of sectors and is a sound core holding. Currently we have issued a Buy recommendation, with a Ranking of 89.

A well-diversified portfolio offers potential upside returns as well as income and downside protection by balancing equity positions and bonds. In addition to regular income, bonds provide an effective hedge against riskier equity investments. On average, bonds have seen negative returns once every six years, and stocks produce negative returns once every four years. The magnitude of the loss is typically higher with equities. Over time, the volatility of a portfolio is reduced if the bond allocation is maintained. Interest rates have been historically low in recent years, thus investment-grade corporate bonds issued by firms with strong balance sheets have been more attractive to investors than Treasuries have been because they offer higher yields with little additional risk.

Interest rates and bond values move as economic expectations change. The current trend indicates that there will be higher yields, which is positive for long-term investors. The Federal Reserve has made it clear that the central bank plans to normalize rates. The recent election resulted in a change in political power that can cause market uncertainty as investors try to figure out the effect on future economic activity, including the growth of the economy, which will affect future Fed policy decisions. Currently, investors are anticipating that the Fed will follow through with its projected gradual increase in rates as policies advocated by the new administration lead to a stronger economy. While this should translate into lower volatility in the bond market, prices may still fall as rates increase, meaning investors must be more selective in their bond choices.

In a rising interest rate environment, investors should shorten durations to mitigate interest rate risk. Selecting bonds can be difficult, and the associated fees may negate any gains. Investing in an exchange-traded fund (ETF), such as the Vanguard Short-Term Corporate Bond ETF (VCSH), should deliver a solid yield and lower interest rate risk, at a low cost.

Launched in late 2009, VCSH draws from a pool of more than 2,000 different short-term corporate investment-grade bonds. The ETF boasts a low expense ratio and tracks the Barclays U.S. 1-5 Year Corporate Bond Index to provide current income with minimal price fluctuation. Approximately 80 percent of the fund’s $15.8 billion in assets under management (AUM) are invested in components of the index. Although corporate bonds carry more credit and quality risk than do Treasuries, domestic firms have significantly fortified their balance sheets in recent years and carry ample on-hand cash balances. An investment-grade company has not defaulted since 2011, and the default rate over the past 30 years is approximately 0.10 percent. Although companies face headwinds including a stronger dollar, profit margins are at a 15-year peak, the economy is growing slowly and overall financial conditions are strong. Consumer spending has increased as confidence reaches multiyear highs and the unemployment rate dips to multi-decade lows. This bodes well for corporate bond issues.

Investment Strategy

VCSH uses a sampling strategy to track the underlying benchmark. Managers select domestic corporate investment-grade bonds with maturities between one and five years that have at least $250 million in value outstanding. The ETF weights the portfolio by market cap and rebalances monthly. The goal is to maintain an average dollar-weighted maturity between one and five years with a target of three years.

The portfolio contains 2,122 individual holdings comprising primarily of debt issued by firms from the financial and industrial sectors, like the underlying benchmark. The holdings consist of an even mix of bonds maturing between one and three years and debt maturing between three and five years. While the average effective maturity is 2.9 years, the average effective duration is 2.75 years. Compared with its category peers, the ETF is overweight AA-, A- and BBB-rated debt. 67.9 percent of the fund’s holdings have coupons ranging from 0 and 4 percent. The fund also has a 23.33 percent exposure to securities with a 4 to 6 percent coupon and a 7.1 percent allocation to debt with a 6 to 8 percent coupon. Less than 2 percent is allocated to bonds carrying a coupon yield greater than 8 percent. The ETF has a 57 percent annual turnover rate. The top 10 holdings make up less than 3 percent of AUM. They include debt issued by Anheuser-Busch InBev, General Electric Co., Capital, Merrill Lynch, JPMorgan Chase, Diamond 1 Financial and Bank of America.

The ETF has above-average return and risk ratings from Morningstar. VCSH has delivered one-, three- and five-year returns of 2.63, 1.92 and 2.49 percent, respectively. The category averages over the same periods were 2.01, 1.09 and 1.45 percent. The ETF has an SEC 30-day yield of 2.28 percent. The fund’s three-year beta and standard deviations are 0.35 and 1.54, respectively. These compare with the category averages of 0.28 and 1.28. The fund has an expense ratio of 0.07 percent, which is lower than that of most of its competitors.

Recommendation

VCSH is suitable for investors looking for an established short-term corporate bond ETF that boasts low trading and holding costs. The ETF helps individuals maintain the fixed-income portion of a well-diversified portfolio while mitigating interest rate risks. This ETF is available as an open-end mutual fund. With a 0.10 percent expense ratio, the Admiral class shares (VSCSX) require a $10,000 minimum initial investment. Trading under the ticker symbol VSTBX, institutional class shares have a 0.07 percent expense ratio and a $5 million investment minimum. Currently, we have issued a Strong Buy recommendation with a ranking of 90. While the returns of the fund are modest, it serves an important role in nearly every portfolio.

Alternative Investments

The closest direct competitor to VSCH is the SPDR Barclays Short Term Corporate Bond ETF (SCPB). With approximately $4 million in AUM, the ETF has a much smaller asset base. While exclusively investing in corporate bonds like the Vanguard fund, SCPB caps maturities at three years rather than five. Limiting maturity has reduced the fund’s volatility, but it has also reduced its overall returns when compared with VSCH.

Another option is Vanguard’s Short-Term Bond Fund (VBISX). This strong competitor maintains a broader, more diversified exposure to the short-term bond market by also investing in government securities. With a 0.16 percent expense ratio, the fund tracks the Bloomberg Barclays U.S. 1-5 Year Government/Credit Float Adjusted Index. The fund is also available as an ETF trading under the symbol BSV.

Software automation advances have led to rapid growth in the field of robo-advisors. These automated online platforms provide algorithm-based investment management without human intervention. Robo-advisors, including Betterment and Wealthfront, now oversee more than $20 billion of assets after starting from nothing in 2010. Large brokerage firms such as Fidelity, Schwab and Vanguard also adopted automated investment services. In 2016, Betterment, Dream Forward and Honest Dollar crossed into the retirement plan space, offering cheaper alternatives to traditional defined-contribution plans as well as digital wealth advisory services.

Robo-advisors vary tremendously in performance. While fees are generally low, some sites assess hidden costs and many don’t offer important features, such as free rebalancing or tax-loss harvesting. Furthermore, asset allocations are based on age and questionnaire responses, which often don’t line up with long-term financial goals and circumstances.

These services do have a few advantages over other types of DIY investing, especially for beginners or those with smaller, simple portfolios. The typical robo-advisor charges less than 75 basis points per year to buy exchange-traded funds (ETFs), although a few firms, such as Charles Schwab, charge no fees. Both investors and advisors save on costs associated with human activities like portfolio monitoring and securities transactions. They are thus able to offer lower account minimums, opening the door to investors with as little as a few hundred dollars.

Hidden Risks

Despite the lower costs and convenience associated with robo-investing, software-dependent methods are not without significant risk. Melanie Fein, former Federal Reserve Board senior counsel, cautioned that because robo-advisors ask limited questions, they are incomplete in their data collection, which may result in suboptimal portfolios. While human advisors do use various forms and questionnaires to guide portfolio selections, they also engage in conversations and build relationships to create customized portfolios for each client’s unique situation.

Some robo-advisors keep fees low to direct investors into their own investment products or those of affiliated brokers. Although there are thousands of mutual funds and ETFs available in the marketplace, robo-advisors often limit investment options to only those products that ensure their own profitability. We have seen this many times before, especially with annuity products. Fidelity and other firms offer a variety of annuity options, but in almost every instance, the investment choices are limited to their own products or those of firms where they are financially incentivized. Fees can be quite low because they control the available choices. Most registered investment advisors have the flexibility to purchase a larger variety of funds.

In some robo customer agreements, clients are charged with all responsibility for investment decisions and account monitoring, whereas investment advisors, even those who utilize a digital investment service, are subject to the Department of Labor’s fiduciary standard of client care. The fiduciary rule, amended in 2016 to provide additional protections, prohibits advisors from making investment decisions that are not in the client’s best interest. Robo-advising has the potential to distance the broker or advisor from the client’s portfolio, placing the burden on the investor and skirting the fiduciary rule.

The surge in robo-advisor platforms is still very new to the industry, with most products launching after 2010. These vehicles and algorithms have yet to face a major market down cycle. This should be concerning for investors. The algorithms that direct portfolio allocations have not been tested in a real-world environment. While back-testing has occurred, investors should be skeptical. At this point we don’t know how quickly allocations would change were we to enter a bear market environment. If a significant market event occurs, we find it highly unlikely robo-advisors would move fully into cash positions, as it would not be profitable for them. There are also few options that allow individual investors to short the market.

The beginning of a market correction may be of even greater concern to investors, as they are responsible for assessing and changing their portfolios with little guidance. Human advisors offer tailored advice to customers in volatile times, and often their flexibility in investment choices provides more protection. In recent years, we’ve also seen a growing number of “flash crashes” as trades grow ever more computer dependent. At this point, we are unsure how a computer-based system will react to rapid market changes. While we assume the models would not arbitrarily sell positions, robo-advisors may not realize the buying opportunity that exists for investors. Having an advisor who recognizes these opportunities of value can be quite profitable.

Incidents at several high-profile institutions have heightened concerns about cyberattacks and insider fraud. While partnering with a human financial advisor may not completely mitigate these risks, it does provide investors with a readily available partner who can help navigate unforeseen challenges.

Automated investment services differ significantly from customized portfolio management designed to address the multifaceted goals of most investors. We have worked with thousands of investors over the years, and no situation has been identical. Tax and estate planning, succession, risk mitigation, and family issues such as care for elderly parents are very personal and unique. With the robo-advisors’ cookie-cutter questionnaires and stylized risk-return models, clients are not likely to receive the best standard of care for their investments and other more personal services.

If you are currently using such a service and have questions about your investment allocations, call me at (844) 336-9878 or email me at matt@mdswealthadvisors.com.