Can Robo-Advisors Evolve? Introducing Robo 2.0
Since the dawn of modern markets, investors have been saddled with major impediments to investment success. Some of these were structural, such as high investment fees and costs. Others were behavioral, with investors succumbing to powerful emotions and biases manifesting as poorly-timed decisions. Some hurdles – such as home bias and poor diversification – can be attributed to simple tradition. And finally, as if relegated to a minor post-script in this story, investment solutions themselves have often been weighed and found wanting.
In the last half decade, a new entrant has emerged to deliver investment management solutions with little intervention by human Financial Advisors. So-called “Robo-Advisors” offer several compelling features for online clients. Most combine an aesthetic online interface with streamlined digital account opening, simple funding procedures, and easy to understand performance reporting. On the back end, they provide simple, intuitive, and inexpensive portfolio management services, with several mixes of stocks and bonds to meet a variety of return and risk objectives. They have raised the bar on transparency with a focus on low-cost underlying investments, mostly index ETFs. Some are aware of the tax status of different accounts, and divide assets strategically to minimize tax impact. Others engage in rules-based techniques to minimize tax impacts and optimize automatic rebalancing. Let’s face it, these are quantum leap improvements over a typical advisory experience.
Robo-advisors also address the bugaboo of traditional investment management: large performance drags associated with the high costs of traditional forms of active management. These costs include high fees, but also the more subtle opportunity costs associated with persistent underperformance. The fact is, stock-picking is hard, and the mutual fund industry has an almost perfect track record of dismal results.
Robo-advisors have been incredibly successful on that front, vaporizing fees through technological efficiencies, and by emphasizing low cost index funds and ETFs. The result is that many robo-advisors now offer portfolios with all-in costs starting at 0.6%, and dropping precipitously for larger accounts. For many investors previously saddled with the high cost of discretionary mutual funds, this transition was unambiguously a step in the right direction.
One way that robo-advisors have successfully depressed costs is by limiting the human element. New clients complete online assessments of their risk tolerances and time horizons, and are then invested in a suitable portfolio. This is well and good, so long as markets generally behave and returns are positive, which has characterized the experience so far. In truth, robo-advisors have largely experienced market tailwinds ever since they achieved meaningful market penetration.
But this prompts an important question: When we inevitably face the next bear market, will robo-advisor clients stick with their plan? Or will they do what humans have always done when faced with a typical 25-50% loss – cut and run?
Figure 1. A taxonomy of human behavioral vulnerabilities.
Source: ReSolve Asset Management
The fact is, investors are humans, and the human mind was never designed to navigate modern markets. We are prone to a host of behavioral foibles that together conspire to undermine our long-term results (See Figure 1).
Of course, robo-advisors are aware that investors are extremely vulnerable to this type of destructive behavior. And they have taken steps to help investors stay on course. These steps include regular emails about how investments are risky in the short term, but ultimately rewarding in the long-term. They also post videos, hold webinars, and provide interactive tools aimed at helping investors build confidence in their approach during good times, so they can stay on course during the bad times.
When the next bear market hits, it’s certain that these robo-advisors will be prepared with a strategic email campaign designed to address how they think clients will be feeling at each stage of loss. Send email number 1 when they are down 5%. Email 2 at -10%. Email 8 at -40%, etc. No doubt the most thoughtful robo-advisors are already developing these campaigns right now, in consultation with the world’s foremost experts on investor behavior.
And maybe – maybe – these campaigns will work, where human advisors, with their ability to empathize, and with the trust that they build with clients over many years, and with the voice of experience, often fail. Maybe.
But maybe it’s just that investors are human, and when faced with what feels like an existential threat, their very nature demands retreat. Maybe there’s no amount of email-automated empathy that can convince a frightened, instinctual animal to hold tightly to investment principles that fail so spectacularly every five to seven years. And if that’s a reality of the human condition, then maybe, what investors really want is to reach their financial goals without the gut-wrenching ride they are likely to get with the traditional portfolios that most robo-advisors offer.
Unfortunately, while robo-advisors are typically thought of as ‘outside the box’ solutions, they mostly embrace the same old methods as traditional advisors. In other words, robo-advisors are flush with technological innovations to lower costs, but they offer little in the way of innovation on the investment front.
Consider that traditional portfolios have many flaws that cause investors to take more risk than they need to, and which are likely to impair long-term performance. For example, traditional portfolios are:
- Constructed using long-term average estimates for risk and return, which may not reflect future conditions OR
- Constructed using complex econometric methods with questionable assumptions, making them highly vulnerable to faulty estimates;
- Profoundly under-diversified, and overly concentrated in stock market risk; and,
- Bound to strategic asset class allocations that do not respond to giant shifts in risk and return expectations.
The fact is, robo-advisors have performed an incredible service by squeezing out every last ounce of marginal cost in the delivery of plain-vanilla, cookie-cutter, commoditized investment solutions. But in terms of adding value to the primary drivers of investment performance, robos have failed to deliver.
And has there ever been a greater need for investment innovation? Let’s face it, basic math suggests that investors– at best – are going to just get their money back after inflation on safe bonds over the next couple of decades. And U.S. stocks, while somehow managing to look cheap relative to bonds, are quite expensive relative to their own history. Moreover, we are much closer to the end of a bull market than the beginning, as the current rise is now the second longest cycle in the past century. Even the ever-optimistic Jeremy Siegel, author of “Stocks for the Long Run” is forecasting stock returns of about 4% real over the next decade or more. Jack Bogle, the lionized founder of Vanguard is on record saying that a traditional balanced portfolio will be lucky to earn 1.5% after inflation. These are grim realities.
Worse, these lower than average returns are unlikely to be realized with meaningfully lower risk. While the lesson of the past five years is that the world’s central banks are always ready and willing to step in and support stock prices, this is a unique phenomenon in the history of markets. As such, it should not be counted on indefinitely. It is quite possible that they make a mistake, or simply lose control of the process. Risk is like energy – you can transform it, redirect it, even contain it for a time – but it cannot be destroyed. Rather, the longer central planners attempt to contain risk in the system, the more likely it is that they will lose all control when the next crisis inevitably hits. After all, if all it took to create lasting prosperity were endless central bank largesse, why are we all working so hard?
Enter ROBO 2.0
Over the past year or so, a new breed of online advisor has entered the space with a mission to take the robo-advisor model to the next level. These solutions also leverage low-cost ETF technology to focus on the parts of the investment process that make the biggest different to portfolio outcomes. However, while traditional robo-advisors have focused largely on cost reduction and convenient online engagement, the new breed is committed to nothing short of a quantum leap in innovation on the investment side.
Consider one of the first entrants in this category, Alpha Architect’s Online Advisor launched in March of this year. The team at Alpha Architect produces an almost superhuman amount of empirical research and analysis, which they offer for free to all investors. They are truly committed to making it as easy as possible for investors to succeed, by introducing them to the most time-tested methods of wealth creation. As such, the goal of their robo-advisor is to provide investors with access to the investment best practices that fall out of their prodigious research process. This is their mission:
“We seek to deliver an affordable, active, globally diversified, downside-protected, asset allocation solution.”
Coming at if from a slightly different angle Mebane Faber is another celebrity in the field of rules-based investing. Truthfully, his early publications on quantitative global asset allocation inspired our first forays into this area of research. Meb is relentless in his mission to democratize the world of empirical finance by providing investors with easy access to rules-based solutions with the highest probability of long-term success.
In launching the Cambria Digital Advisor, Meb appears to be realizing his long-term vision. His online solution applies Meb’s “Trinity Portfolio” concept to combine the most powerful forces in markets to deliver genuinely innovative wealth management solutions. What does this mean? It means systematic exposure to robust rules-based methods to boost returns while managing downside risk. Imagine that.
Thanks to the groundbreaking efforts of firms like Alpha Architect and Cambria, the ReSolve team was inspired to throw our hats in the ring through our own unique take on rules-based investing with ReSolve Online Advisor. Even better, our active ETF managed portfolio solutions are able to harness every tool in the investment toolbox to provide investment solutions optimized to meet almost any return and risk objectives, with the stable return experience and downside protection investors have come to expect from ReSolve.
Figure 2. ReSolve Adaptive Asset Allocation 8% Volatility (USD) Index
The ReSolve Adaptive Asset Allocation: 8% Volatility (USD) Index is based on simulated performance. About this data.
The ReSolve Online Advisor provides simple access to three groundbreaking investment solutions, either on their own or combined to optimize different return and risk objectives. Investors have options suited to registered accounts such as IRAs and 401ks, as well as a wider variety of solutions in margin-eligible accounts. As such, our “Robo 2.0” solution goes well beyond what is available in traditional investment products to target the highest ratio of excess return to risk, at any reasonable return or risk objective.
Figure 3. ReSolve Investment Solutions
Clients of the ReSolve Online Advisor will have access to the following strategies. Note that ReSolve Risk Parity and Adaptive Asset Allocation mandates are offered at a variety of volatility targets for marginable accounts. Given the nature of these robust solutions, we achieve higher targets for risk and return by allowing leveraged exposure where we estimate the underlying portfolio volatility to be less than the target. The leverage ratio is evaluated at each rebalance to ensure the portfolio is always positioned to meet its volatility target, in any environment.
There’s no denying that the old guard delivered on its mission to drive fees lower. The problem is that fees were only the beginning. ReSolve Online Advisor is what comes next.