Robo investing is becoming all the rage among Millennials, the generation born between the early 1980s and 2000. By robo advisory, I mean an automated, algorithmic investment product. It works this way: Joe the investor completes a questionnaire intended to assess his risk profile, expected retirement age, heath, wealth, income and other matters. Given these inputs, a computer program automatically generates a low-cost “efficient” portfolio for Joe. If he accepts this portfolio the program executes the indicated trades and creates the portfolio using low-cost index funds, typically ETFs.
The portfolio created varies with both the investor profile and the type of account. IRA accounts hold taxable fixed income, while taxable individual accounts may or may not, depending on the tax bracket of the investor. Special tax harvesting algorithms take tax losses in the taxable accounts and reinvest in similar ETFs to maintain the strategy. The program rebalances portfolios based on some formula wherein the winning positions are trimmed back to their target percentage and the proceeds are used to buy more of the losers.
This maintenance activity happens automatically without the individual investor’s involvement; presumably, our friend Joe is too busy with other aspects of his life to attend to his investments. Or perhaps he hasn’t yet amassed enough investable assets to meet a traditional advisor’s account minimum. The robo service is ideal for Joe. Since he doesn’t call, email, or meet with an advisor, the service is very inexpensive. And his small nest egg is no barrier; a robo account’s minimum value can be very low. Even a few hundred dollars will suffice at some advisors. Thus the robo product is a better choice for our Millennial friend Joe than a self-directed brokerage account would be. Maintenance is built right in, so Joe can virtually ignore his investment account without fear.
Imagine, a money machine for the investor and the advisor with only the computer in between! As one young friend told me, “. . . the automatic teller machine (ATM) mostly eliminated the need to wait in line at the bank for cash. Robo advisors are performing the same type of service.” Investment advisors should know that they may be disintermediated by artificial intelligence and algorithmic portfolio management. Certified Financial Planners (CFPs) and Chartered Financial Analysts (CFAs) will be replaced by Care Free Program Algorithms (CFPAs). It gets even better: CFPAs do not require vacations, sick days, ever-increasing compensation or ego massaging. They are robots par excellence! What do I think the future of the CFPA is? I actually think it is pretty good.
I predict that the entire “robo” model will be reworked following the first down 30%+ bear market. Here is why. In approximately 50 years in the investment business I have seen nearly every investor, big or small, rethink his risk return desires at some point beyond minus 20% to 30%. During the 1973-74 equity bear market, I got called on the carpet by an institutional client after I rebalanced the portfolio. The investment committee demanded to know how I could be so stupid as to sell the winners and buy the losers. I was still green—only a few years out from receiving a Ph.D. and practicing as a finance professor—so I tried to discuss mean reversion and relative valuation, and I gave concrete examples. It did not go well, but they stuck by me long enough to see huge gains in 1975 and beyond.
I think I can almost see the future. My robo account is down 20% and I am relieved to see a flurry of trades. All my winners are trimmed and I own more of the losers. At down 30% it is more of the same. As the year-end approaches, I am down 40% from the bull market peak and in my robo taxable account the tax harvesting algorithm kicks in. All my losing positions, which is nearly everything, are sold and the proceeds invested in new ETFs with similar goals. The robo advisor sends me an email assuring me that this is all according to plan and, by the way, would I please refill out the questionnaire I did at the outset of my program just in case my risk tolerance has changed. I think this is the point where a cute bouncy avatar appears on the robo advisory program screen, offering to hold my hand.
Are robo advisory portfolios advisable? My current view is a resounding yes, for small amounts of money and especially when the investor is adding to the account on a regular basis. Robo algorithms that keep the account fully invested, rebalanced and highly diversified in low-cost index funds offer an enormous advantage over a self-directed brokerage account. Real time valuation and tax harvesting, along with tax records, are valuable adjuncts to such programs. The great unknown is what happens to the no-contact concept between the advisor and the client when the next black swan flies into our markets? The financial success of the robo advisory business is driven by low fees and no handholding. Imagine going to the ATM and checking your balance only to discover instead of the $5,000 you thought was there you find only $2,500. Now where is that teller?
Labels: Opinion