It has been my hypothesis for some time now that the rise of the exchange-traded fund, or to be more specific the ultra low-cost, indexed ETF has made possible the growing wave of online, algorithmic asset managers (or robo-advisors).* In short, this abundance of low-cost portfolio building blocks available from a host of fund sponsors makes low-fee online portfolios possible. A couple of years ago I noted that most investors’ portfolio needs are not all that unique. Therefore algorithms could handle the bulk, but not all of their needs. I wrote:
There simply is too much juice in the 1-2% annual management fee to not see that disrupted. Especially if you take the view that the vast majority of investors do not, despite their desire, need a custom portfolio. Creating algorithmic approaches to portfolio management will be the easy part. The hard part will be finding those individuals willing and able to help clients with the big money decisions.
Felix Salmon at Reuters has a post up discussing the value proposition of Wealthfront and Betterment, two of the more prominent firms in the online investment management space. In his piece Felix adjudicates some differences between the two services but by and large is positive on the ability of these firms to provide real value to investors. He concludes:
Betterment and Wealthfront both have higher fees than Vanguard, but give you real value in return for those fees. Wealthfront’s value is more quantifiable, and the company makes an extremely strong case that it delivers more than 25bp in value for the money that it’s charging. But Betterment’s value is also important. There’s a large and distressing difference between investment returns and investor returns: investment returns assume a perfectly rational buy-and-hold investor, but humans don’t behave that way…If Betterment’s behavioral-finance based user focus can substantially narrow the gap between investment returns and investor returns, that could be just as valuable as all of Wealthfront’s bells and whistles.
Andy Rachleff, CEO of Wealthfront, in a recent interview said that the big idea behind his business was that: “Everyone deserves access to sophisticated investment management.” In that light a recent addition to Wealthfront’s product slate is stock-level tax-loss harvesting. You can read the details in their white paper. For taxable investor tax-loss harvesting is a big underutilized opportunity. By letting the computers do your tax-loss harvesting in the background you can focus on things that are more salient to your daily life.
A couple of weeks ago SigFig which was more known more for account aggregation jumped into the online investment management business with a twist. SigFig plans to charge just $10 a month for portfolio management regardless of assets under management. This is potentially a big deal in a world full of financial advisors charging 1% of AUM a year. It will interesting to see if SigFig’s model is able to grab market share not only from offline managers but the raft of online managers as well.
Leigh Drogen is skeptical of SigFig and the other online managers. First he is concerned that once the hedge funds and algorithmic traders figure out how these firms move money around they will get picked off in the market. Second, and I think the more valid point, is that investors who sign up for these low-cost services are still subject to the the psychological ups and downs of the market. Drogen writes:
(N)o matter how automated you make things, humans can still pull the plug, which they almost always do when things go bad, which they always do at some point, because that’s what happens in the market. Your mom will still go in and sell everything because SigFig can’t lock here out for her own good when volatility spikes…
Which I think is a valid point. The value of these services only plays out over full market cycles. Investor’s hair-trigger responses to market losses is one reason why investors who play the active management game lose so often (and so consistently). Joshua Brown at The Reformed Broker has a great post up looking at the lack of persistence in active equity mutual funds.
Active management works, it just doesn’t work for most people. And when you look at the dollar-weighted returns for investors in mutual funds rather than the time-weighted returns tracked in the media, the picture is even bleaker. High-cost, mean-reverting investment vehicles paired with the rearview mirror-guided timing of average investors is a deadly cocktail.
Avoiding this “deadly cocktail” is one of the potential benefits of giving your portfolio to a third-party manager regardless of whether they are online or offline. Putting a buffer between you and your worst instincts is a valuable service. The only difference is now you don’t have to pay someone 1% or god forbid a front-end load on a mutual fund to get some value added.
These online services are not for everyone. Some investors might resist the temptation to mess with a managed portfolio if they keep some “funny money” around to trade to their heart’s content. The bottom line for online investment management is still the same as it was when these services were still getting off the ground. The conclusion to a post I wrote:
It may be a bit of a downer to think you and your portfolio are not all that unique. As we note in our forthcoming book most investors don’t want to trade, but simply want portfolio solutions that save them time and make their lives easier and less complicated. So for a wide swath of investors these sorts of services provide for the prospect for lower costs, better returns, less hassle and most of all more time to spend on the more important things in life.
That sounds about right especially in light of the strides these firms have made in the past couple of years.
*Apologies for not putting this post out earlier. Amidst the holiday rush these tabs have been sitting open on my computer for weeks now.
Update: Joshua Brown at The Reformed Broker weighs in this morning with seven (reasonable) thoughts on the robo-advisor trend.
Items mentioned above:
Do you really need a unique portfolio? (Abnormal Returns)
How online investment managers add value (Felix Salmon)
Andy Rachleff: Democratizing the Investment Business (Stanford)
Introducing a new level of tax-loss harvesting (Wealthfront)
The real problem with SigFig’s $10 portfolio for everyone (Leigh Drogen)
Persistence is a killer (The Reformed Broker)
Investing as a hobby (Abnormal Returns)
You are not all that unique an investor. (Abnormal Returns)