Recently the financial advisory business has seen the launch of many “robo-advisors”; websites that leverage technology to provide portfolio management services to clients without anxiety-inducing human interaction. These sites, such as Wealthfront and Betterment, typically ask the user a few simple questions and spit out a recommended portfolio based on the responses. The user can invest in that portfolio for a very low management fee (0.25% seems to be about the going rate) and there are very low or no minimums making it accessible to almost everybody. I think these services are a great concept because they are disrupting the old-school financial advisory business that has long been over-charging and under-advising clients. There are some drawbacks, however.
Anheuser-Busch spent the latter half of the twentieth century gradually removing hops from Budweiser to make the beer more palatable to the masses. It’s not what most would consider a great-tasting beer, but it is “drinkable” in the sense that you can pound a 12-pack in one sitting without the flavor building up. This, along with the advent of the U.S. interstate system, allowed them to mass-produce and mass-market the same beer from coast to coast. In a similar way, these robo-advisors have used the internet to offer a simple solution that is suitable enough for the everyman.
The process is typically well founded and the asset allocations they build are good — good, but not great. The portfolios at Wealthfront, for example, include only six to eight ETFs depending on your risk score and the tax status of the account. They cover a lot of ground in the investable universe, but ignore some key asset classes that can help provide broader diversification and better returns in an effort to keep it palatable enough for some common denominator. But just as some drinkers prefer a robust, full-flavored beer, many investors are looking for a more personalized portfolio that better matches their tastes. They also invest quite heavily in international stocks, which those favoring the domestic brews might not be comfortable with.
Wealthfront doesn’t currently report performance, but they do show their model allocations on their website so we can do some back-of-the-envelope calculations on our own to see about how well they did last year. Keep in mind that without knowing their rebalancing schedule we can’t determine exactly what performance would have been for their investors. Let’s say you are a moderate investor and your answers to Wealthfront’s series of five questions results in a 5.0 on their 10-point risk tolerance scale. This gives you the following mix:
A total return of 5.62% (5.37% if we subtract the 0.25% fee) for 2014. That’s a bitter beer to swallow when viewed next to the 10.99% return of a simple, yet comparable benchmark with a mix of 65% in the S&P 500 and 35% in the Barclays Aggregate bond index. The underperformance is even more severe if you invested in their most aggressive portfolio, which is 90% stocks. That would have only given you a return of about 2.84% after expenses compared to the S&P 500’s return of 13.69%. The underperformance is largely tied to their heavy allocation to international and emerging market stocks, which underperformed U.S. stocks and unfortunately made up more than half of the equity portfolio. That’s not to say these allocations aren’t going to have good years, I’m just pointing out that 2014 wasn’t one of them.
Additionally, with short questionnaires that take less than a minute to fill out a robo-advisor doesn’t even scratch the surface of proper financial planning and advice. It doesn’t come close to replicating a skilled professional who is going to take the time to sit down with you and walk you through everything. It simply can’t get a clear picture of your investment goals or your risk comfort zone. It won’t delve down into your tax situation to better manage your portfolio towards it. It doesn’t understand who you are or take into consideration any of your investment preferences. It isn’t available to answer all of your questions or provide retirement or trust and estate planning. And most importantly it isn’t there to guide you through market extremes where investors are most inclined to make emotional mistakes.
“It’s a machine, Schroeder. It doesn’t get pissed off. It doesn’t get happy, it doesn’t get sad, it doesn’t laugh at your jokes. It just runs programs.” – Newton Crosby in the film Short Circuit
Robo-advisors are a good thing overall and they are doing a lot to open up the investing world, making it more accessible to smaller investors that are often ignored by professionals. But financial planning and investment management are not a one-size-fits-all domain, so robo-advisors are not likely to replace skilled investment professionals. They do, however, offer a low-cost solution to meet the needs of the average Budweiser drinker.
