Beware of the Robo-Advisor and Other “Smart” Investment Solutions

July 18, 2016

By Daniel Cohen

The financial services industry has undergone changes since I entered it more than two decades ago, and it seems to be changing at an accelerated pace in the past few years.  Just like many other industries such as lodging (Airbnb) and transportation (Uber), financial services companies are now competing with technology-based competition from firms like Betterment.

Many of the changes in the financial services industry over the past decades have been to drive cost down.  However, some of the recent changes may actually increase the cost of investing, and many high-cost investments are still popular.

Trading stocks today costs a fraction of what it did a few decades ago, and funds that track the movement of the broad market have minimal cost. Most of today’s investors probably don’t know that prior to 1975, the government regulated the commission on a stock trade. Because the commissions to traders and fund managers have dropped so much, and trading online has become so easy, there is less opportunity for companies to earn income from trading commissions or from generating investment management fees. Only the largest of money management firms, some having trillions of dollars under management, can achieve the scale necessary to make money on funds with such low cost structures. Investment management firms are always looking for ways to raise revenues, which ironically adds cost to the investor in their low margin industry.

As defined by Investopedia, a robo-advisor is an online wealth management service that provides automated, algorithm-based portfolio management advice without the use of human financial planners. These services emerged as a new way to generate advisory fees on a large scale using today’s mobile technology. The focus of robo-advisory firms is purely on investment management and not on financial planning. They invest solely in funds rather than individual stocks.  There is a perception that if a service is automated then it will cost less. Robo-advisory firms actually add an additional fee layer on top of the cost of the funds they are buying for their customers.

“Freeze! No trading!”

Robo-advisors are automated programs.  There is no dedicated advisor to call when the market experiences a high level of volatility. In the recent brief selloff after the Brexit vote, one leading robo-advisory halted trading in their service which prevented customers from getting out of their positions or adding to their positions to take advantage of the correction. The Massachusetts Secretary of the Commonwealth, William Galvin commented that, “these customers were put at a great disadvantage. The precedent this sets is a real bad situation where people are desperate to get liquidity and they can’t.”

The markets quickly recovered after Brexit, but what if the correction was not so brief?  How would these automated programs have handled things?  The history of most robo-advisors is too short to judge whether the extra cost of the service improves performance, even though the services claim to expect better performance than a typical “do it yourself” investor. One study from 2014 showed no better result from the robo-advisors compared with the broad market indexes.

Another recent development in the financial services industry has been the development of many “smart beta” strategies. The strategies attempt to outperform the market indexes by weighting various factors differently than their weight in the index. There are many skeptics of these funds, and they carry additional risk.  Burton Malkiel, the retired Princeton University economist, has been a strong proponent of index investing for many years primarily because of their low cost. He argues that low cost indexes outperform actively managed funds over time because of their low turnover and better tax efficiency.  His book, “A Random Walk Down Wall Street” was first published 43 years ago. In a recent update, he concludes that smart-beta strategies aren’t right for individual investors because they are riskier and have long periods of underperforming the stock market. He says that smart beta is just a new way for fund managers to justify higher fees.

Cost is definitely an important factor in choosing an investment program, and the reduction in the average cost of investment management programs has been generally positive for investors.  However, there are many other factors that help determine the long-term success of a financial plan. For example, tax efficient investing can have a big impact on the performance of an investment program. The particular type of investment account you choose can have a large impact on future retirement income. Taking advantage of the tax benefit of qualified dividends can also make a big difference.

Some people choose to invest on their own without the assistance of a financial planner, and many do it well.  However the typical “do it yourself” investor does underperform the market for a variety of reasons. Many of the mistakes are behavior related, such as buying or selling at the wrong time and emotionally based investment decisions.  A well experienced Certified Financial Planner will keep his or her clients on track to reach their goals and will help avoid those behavioral based investment mistakes.

How do you define “smart” financial service? 

All professions are facing challenges from new technology-based offerings. Even telemedical advice is now being offered by many health plans. Predictably, those professionals that deliver a high value of advice to their clients will not only remain in business but will prosper as the need for customized personal advice is growing. Those that provide a commodity-type service or that fail to monitor and understand dynamic information won’t be able to compete.

In my financial advisory practice, we charge a single, all-inclusive advisory fee which covers comprehensive financial planning as well as investment management.  Our clients primarily own individual stocks, and sometimes the stocks are complemented by low-cost funds for diversification. We avoid the “smart beta” funds and don’t need help from a computer-generated algorithm.

Our “smart” approach to investing is evident when I meet with clients who have been with me for many years; people who are living the lifestyle that they set out to enjoy. I feel especially “smart” when talking with my 90-something clients who are still traveling and exercising, and I share their stories and investment strategies with my younger clients so that they will similarly be enjoying their most senior years.

I plan to continue investing in quality dividend paying stocks as well as maintain a low turnover to keep investment and tax cost to a minimum. I’ve always been open-minded about all matters concerning the financial services industry, my business, and what works best for my clients. I pay close attention to new opportunities that may include the use of advanced technologies. That’s why my firm has invested in the latest research, financial planning software, and investment management tools.

We’ll keep an eye on automation, but for now, the early evidence is in which suggests that robo-advisors have limits by which an experienced human being with foresight is unencumbered.

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