Robo advisers have become a hot topic on Wall Street and in the financial media in recent years as the asset class continues to grow and draw assets away from traditional mutual fund managers.
The main idea behind robo advisers is they offer a portfolio, perfectly tailored to your risk and reward objectives, at a minimal cost. There is some debate as to whether or not these new upstarts do provide a better service than traditional wealth managers, especially since the entire process is automated and there is no one to pick up the phone if something goes wrong.
Still, the benefits of using robo advisers are obvious. For the unsophisticated investor, they offer exposure to various asset classes a new investor would not usually consider as well as guidance on asset allocation (experienced investors might also benefit from the diversification). The returns seem to stack up as well, although if you are more experienced, it may be better to construct your own robo-based portfolio.
A look at the returns
Analysts at Bernstein have set out to try to analyze robo adviser returns in the context of the broader market, comparing them to other instruments. The analysts set up four portfolios at two leading U.K. robo advisers in October of last year. Two portfolios were created at each adviser, one low-risk and one high-risk. The low-risk portfolios had a 60% to 40% equity-bond mix while the high-risk portfolios were allocated 80% and 20%. As a benchmark, Bernstein’s analysts compared the returns of these portfolios to a combination of the Vanguard Total Stock Market Index ETF and Vanguard Total Bond Market Index ETF.
Interestingly, only one of the high-risk portfolios actually outperformed its benchmark. The other high-risk portfolio underperformed the same allocation with Vanguard funds, and both low-risk portfolios underperformed similar Vanguard allocations. These estimates do not include fees, which can be substantial, ranging from 0.25% to 0.75%, excluding the underlying acquired fund fees. Vanguard’s fees are less than 0.1%.
These returns show that while robo advisers may offer some advantages, outperformance is not one of them. That said, it is arguable that robo advisers have never touted outperformance as their key selling point. Instead, these managers sell themselves on risk matching asset allocation and low fees (although not as low as a Vanguard fund).
A place in your portfolio?
Personally, I believe that while robo advisers should never constitute your entire portfolio, there is a place for them in every investor's diversification strategy. Plenty of research has shown active investment management and stock picking tends to underperform over the long term. That said, some managers do outperform, and while the bulk of individual investors underperform over the long term, some will do much better than the rest of the universe.
Nonetheless, as I have said before, there is a strong argument for every investor to devote a portion of their portfolio to an index fund. This allocation should help psychologically to maintain returns when value has fallen out of favor (or whatever strategy you choose to follow), and if your stock picking strategy starts to lose its edge, at least you will have something to pick up the slack. There is also a strong psychological advantage to this strategy as well. If you know a portion of your portfolio is going to match the market while your value picks lag, there is less pressure to sell up and move on.
By essentially outsourcing a particular part of your portfolio, you can afford to take a longer-term view without being pressured into making any decisions. Robo advisers could easily make up a large portion of this passive side of the portfolio. The aim of this is not to try and beat the market, but give a psychological benefit and match market returns with more diversification in the rest of the portfolio. With computers managing a certain percentage of your equities, you will have more time to devote to the single stocks you have chosen. And if the worst-case scenario unfolds and you suffer a permanent capital impairment, you will live to fight another day.
So overall, while robo advisers and passive funds may not be the best choice for every private investor, there is an argument to be made for their inclusion as part of a well diversified portfolio.
