Can robo-advisors help you manage volatility in your portfolio?
Automated investment management tools, fondly called robo-advisors, are rapidly growing popular. While pioneers of robo-advisors had the ambition of upending the legacy wealth management industry, those who would have been the victim of the technology are quickly embracing it. Goldman Sachs (GS), a renowned provider of financial advice to some of the world’s richest and powerful individuals, recently put up a job posting on its website where it is seeking to hire experts to develop its robo-advisor platform. Other large investment banks and firms such as Morgan Stanley (MS), Wells Fargo (WFC) and Blackrock have also shown interest in robo-advisor technology.
The major draw of automated investment tools is that they help investors to reduce their investment costs and give them access to a broader range of investment options. Investment firms are using robo-advisors to select and manage investment clients’ portfolios.
Consulting firm A.T. Kearney estimates that robo-advisors would be handling about $2.2 trillion worth of assets under management by 2020. Nearly 50% of that money will come from already invested assets and the rest will be new investment. The firm estimates that about $0.3 trillion assets under management were being supervised by robo-advisors in 2016, suggesting that portfolios under the supervision of robo-advisors will grow at an average annual rate of 68% over the next five years.
Are they really better at managing volatility?
What’s the track record of robo-advisors, are they better than human advisors in navigating market volatility? This question has become increasingly important as assets under the management of automated investment systems continues to grow.
Betterment and Wealthfront are among the pioneers in deploying robo-advisors to help guide investment decisions. It may be difficult to compare and contrast the track record of robo-advisors among themselves and against human advisors because of a shortage of data to do that kind of job. However, a look at how robo-advisor pioneers operate can offer a hint about whether or not they are better at managing investment risks for clients.
Case study: Betterment
A case can be drawn of Betterment. The firm has more than $7 billion in assets under management, up from about $5.1 billion in 2016. It uses algorithms to scan the market for risks. As such, Betterment has a policy of not trading near the market open. Instead, its trades begin about 30 minutes late after the markets opened. It can also suspend trading on the days when markets are likely to be volatile, like the day the Federal Reserve is scheduled to update on interest rates adjustments.
Betterment has halted trading for several hours on certain days to avoid exposure to market volatility. June 24, 2016 was the day Brexit results came out that Britain had decided to pull out of the European Union despite most polls showing that Britain would vote to remain in the economic bloc. To protect its clients from losses that could arise from market reaction to the stunning Brexit vote outcome, Betterment kept off the markets for several hours on June 24.
It had made a similar decision about a year earlier when on August 24, 2015 it stayed on the sidelines to avoid exposing clients to market volatility caused by concerns of economic slowdown in China.
Interestingly Betterment didn’t inform clients about halted trades until it had resumed trading, suggesting the control that automated investment tools can have over client portfolios.
Case study: Wealthfront
But Wealthfront, another pioneer of robo-advisor with nearly $4 billion in assets under management, seems to be the opposite of Betterment. It didn’t suspend trading on June 24 following the Brexit vote. In fact, it has never done that before on the basis of market volatility.
However, several robo-advisor firms have measures to reduce investing risks for their clients. By policy, some will not enter the market when it has just opened and will exit the market several minutes to close. These are part of the precautionary measures designed to ensure that clients do not overreact to market movements in a way that could subject them to unnecessary losses.
In the case of Betterment, the firm says it is focused on long-term investment decisions. As such, it doesn’t serve the interest of day traders who seek to make quick bucks from short-term market swings.
While some of these robo-advisors have policies of entering the market about half an hour late and exiting the market about half an hour early, some allow clients to override their decisions if they believe that can enhance their returns. That sounds like a client calling their human advisor at Goldman, for instance, to request that their portfolio be invested in a certain way.
Regulation to play catch up
As robo-advisor services continue to draw the attention of investors, federal regulators have stepped in to ensure that investors know what they are signing up for when they leave their portfolios under the care of automated investment tools. The Securities and Exchange Commission has sent out investor alerts and asked firms that offer robo-advisor services to be more transparent with their clients. Investors on the other hand have been advised to ensure that they are conversant with the terms, conditions and limitations of automated investment services they are purchasing before they sign on the dotted line.
However, the SEC hasn’t taken on any robo-advisor over violation of its terms. The alerts from the SEC can partly be interpreted as acknowledgement by the federal agency that robo-advisors are here to stay and those involved with them should strive to play by the rules and avoid unnecessary risks.
While robo-advisors are gaining currency, they are likely to co-exist with human advisors for several years before machines can eventually take over the job of wealth management.