Is Your Portfolio Managed By Robots?

By Miles Clyne

If you have not already, you will soon come to hear about Robo Advisors.

 
 

These are online firms which have model portfolios that you can invest in at very low prices. The term robo or robot refers to the fact that once your money is invested into a strategy, it follows one of their automated models and is rebalanced systematically (robotically). You may get to talk to real people, but your investments will be managed mechanically.

The cachet of these firms is that they offer their products at very competitive prices. The way they do this is through a combination of low-cost investments like exchange traded funds (ETFs), low trading fees and low administration fees. 

One of the advantages is that low cost investments like ETFs typically outperform most of the “managed” investment products on the market, like mutual funds.  So you get two benefits:

1. Lower costs

2. Potentially higher performance.

This basic approach used by robo advising is nothing new. Many “face-to-face” investment professionals that you might deal with use the same type of strategy, and they often use ETFs as well.

A guy name Harry Markowitz came up with the underlying philosophy behind this strategy in the 1950s and it is called Modern Portfolio Theory (MPT). The financial industry adopted the “theory” and made it mainstream. Robo advisors have just taken this same theory and made it lower cost. 

You have likely experienced this theory if you deal or have dealt with a bank or institution where you filled out a questionnaire and were recommended a “model portfolio” that “theoretically” matched your risk profile. The only difference between this and robo advisors is that you pay a higher fee and hopefully get some additional financial advice to justify the higher price. If not, then the lower cost option makes total sense.

The problem associated with asset allocation based on MPT, is that it is dooms every investor that uses it to a series of failures -- past, present and future. I used to subscribe to this approach in my early days of investing, until it became obvious that it was not delivering, and why it wasn’t delivering, the expected results.

There are a number of reasons for its lack of performance. I will point out one of these: Modern Portfolio Theory, and by extension most robo advising strategies rebalance portfolios frequently. Rebalancing frequently often reduces returns. Returns are reduced because the average investment cycle is usually between 5 and 10 years. This means certain asset classes are rising for that length of time, and the others will be anchors at best on the returns of the portfolio. In these strategies, you will virtually own something of everything (the industry calls it diversification, but it often becomes dilution). You will be consistently selling some of your winners, and buying more of what is performing poorly, every time the portfolio gets “rebalanced”.

These strategies rebalance your portfolio at least annually, and some far more frequently. At some point (maybe on average once every five or 10 years) it will have been of value to rebalance. But every time it is wrong, it costs the investor. So at the very best, your future with robo investing, or a similar asset allocation approach with a fee-based advisor, is the average performance of the markets you own in your portfolio, minus their fees and the additional underperformance this process often delivers due to the rebalance logic. Our team has built software over decades that measures this. It is why I cannot subscribe to the process. Yet shockingly, it is the norm in the financial service industry today in spite of great evidence that it should not be. 

As more and more investors are attracted to this type of portfolio management, based on traditional MPT and asset allocation models, it becomes easier to stand out from the crowd. For the advisor who is actually prepared to do a reasonable job of analysis, it becomes easier to prove their value to their clients through outperformance and guidance.

I wrote two blogs in September 2015, noting the two questions an investor needs to be able to get answered from investment professionals prior to investing:

#1 The Two Mandatory Questions Every Investor Should Ask Themselves

#2 The Two Mandatory Questions Every Investor Should Ask Themselves

If investors followed the advice in these blogs, they’d be able to determine who they should deal with and why they would have the greatest likelihood of actually delivering superior performance net of fees.  The real cachet is being an educated investor - not buying into slick marketing, wherever it is coming from, and that isn’t theoretical!