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.