CKBlog: Technology

Tuesday, April 18, 2017

A Human’s Take on Robo Advice

In my world, so-called “Robo Advisors” are a hot topic. So much so several of my non-finance friends have begun to ask me to explain what “Robos” are and how they work. I learned a long time ago that analogies are useful when describing complex subjects. I have also learned that people love movies. So it comes as no surprise that when trying to explain Robo Advisors, I reference the 1987 classic RoboCop.

Robo Advisors first hit the mainstream in 2008 and have gained significant traction ever since. Three pure-play Robo startups which have enjoyed the fastest growth in assets under management as of this writing are Betterment (over $7 billion of assets under management), Wealthfront (over $5 billion of assets under management), and Personal Capital (just shy of $4 billion of assets under management). There is no doubt: these firms have been very successful at gathering assets. So what are they offering? What is their secret sauce? They are offering low-cost, automated investment services. Their secret sauce is technology—the “Robo” in RoboCop.

After a new customer fills out a risk tolerance and investment objective questionnaire, the software recommends a particular investment strategy, usually implemented using low cost exchange traded funds (ETFs). Technology then takes over as the portfolio automatically adjusts to market fluctuations and some will even make changes to try and minimize capital gains taxes toward the end of the year.  Customers cannot pick their own stocks and cannot customize their robo portfolio. No human interaction is required and portfolios tend to be restrictive which enables these services to charge very low fees.

At Wealthfront, your first $10,000 is managed for free (yay!) and anything above $10,000 comes with an ongoing fee of 0.25% per annum—well below the advice industry average of around 1% per annum. As you would expect, these services have been very popular with those just getting into the investment game and therefore typically have smaller account values. Millennials are also drawn to the technological features and simple, intuitive user interface. You may be thinking that this service sounds an awful lot like the age-based funds (so-called “Target Date Funds”) offered to you inside of your 401k. You know, the ones which become more conservative automatically as you approach retirement age? And you’d be right. Automatic rebalancing has been around for many years. So, what is novel about Robo Advisors compared to age-based portfolios?

In my view, there are two major differences. The first being that as technology gets cheaper, Robo Advisors have been able to develop and scale their services at lower cost than age-based funds have in the past. Second, and perhaps the most meaningful for Robo’s growth, is the ease of its user interface. A person can pick up their smart phone or iPad and, within minutes, can open and fund an account. Seconds later, the portfolio is invested. Robos have done a fantastic job of creating a simple onboarding experience.

Another aspect helping propel the Robo Advisor success is their services were first rolled out to the public just after the 2008 financial crisis. US Equity markets have enjoyed a steady upward ascent since March of 2009. In turn, Robo customers have seen their account balances grow steadily over the years. But it will not always be this way. While some of the Robo algorithms have been back-tested going back nearly 100 years, there are two things they cannot test for: (1) how their customers will react during the next major correction; and (2) how their back-tested algorithms will react to the next downturn.

Will customers remain comfortable with the restrictive “set it and forget” approach when they see their account balance decrease by 10 or 15 percent in one month (as the global markets did last February)?  Or will many customers, lacking the coaching from a seasoned professional human, grow too anxious and close their account at just the wrong time. History tells us that most investors invariably tend to buy at market tops and sell at market bottoms.

In times of stress, real, live advice (from humans) matters. And it also matters when you are contemplating buying your first home, when you are assessing the financial impacts of taking a six-month sabbatical to travel, or when you are approaching retirement and are trying to figure out the best way to pay yourself for the next 40 years.

In summary, Robo Advisors are offering plenty of “Robo” but very little “Cop.”  While there is no doubt that technology enhanced RoboCop’s ability to keep order in 2028 Detroit, his bionic armor was only one part of the equation. As Sony Pictures aptly points out in their plot synopsis of the 2014 remake, “there is still a man inside the machine pursuing justice.” Humans matter.

Several of the custodians we use (where our clients’ funds are held) are now offering “Robo Technology” to us and our clients. Our Investment Committee has begun a deep dive to see if and how we can leverage this technology to enhance our clients’ experience.

My inclination is that this new technology will be a useful addition to our firm and will add value to certain segments of our client base. I expect it to help us streamline our trading and rebalancing processes and may make it more cost-effective to welcome more clients into our practice who are in the earlier stages of building their wealth.

We have always embraced new technology. We will take the same approach when evaluating Robo Services. I look forward to sharing our findings with you. Preferably, in person.