As I wrote in What is a Robo-Advisor?, I spent some time learning about the various robo-advisor offerings in Canada. I concluded that it’s a valid offering, and that it may even be the best choice for many people.
While reading through the websites, however, I realized that much of the content was either exaggeration, marketing half-truths, or downright misleading. These are my observations.
They are not hiring financial wizards to work with you. This was one of the more entertaining claims. I am certain that each firm has hired a small number of wizards to create the program. The program consists of formalizing their thinking and encoding it into questionnaires and processes. Then, they hire minimally-qualified clerks to man the phones.
The portfolio is not personalized, or created just for you. After you complete a questionnaire, you are slotted into one of five generic portfolios, based on your goals and your ability to stomach market fluctuations. This is not a precise science, so grouping you with similar investors is probably good enough.
Next, your account is automatically rebalanced, depending on market performance. For example, if stocks outperform, the program sells stocks (sell high) and buys bonds (buy low). The automatic rebalancing is not based on your account, but your pre-packaged portfolio, so your account could be rebalanced just days or weeks after investing. There are two ways to achieve this, either based on market performance (stocks rise more than x% relative to bonds) or on time (once a quarter, check if stocks have risen or fallen relative to bonds). Either way, it depends on market movement, not the results in your portfolio.
Rebalancing also takes place in actively-managed mutual funds, but based on human judgement. This is essentially what you pay for. Further, uninformed rebalancing is not uncontroversial. For example, if stocks are performing better than bonds, you give up potential return when you sell stocks. In hindsight, stocks have outperformed bonds roughly four years out of five, so rebalancing more frequently reduces potential return.
The savings are purely hypothetical. What actually matters is performance net of fees. If raw performance is identical in two funds, the one with lower fees will produce higher net returns. However, If you pay less but earn less, that’s not as helpful to your long-term financial success as earning more after costs, even if you pay more for it. Example: $1000 + 5% return – 0.5% fee = $1045 or $1000 + 8% return – 2% fee = $1060. The caveat is that return is not guaranteed, while fees are. From the research that I’ve read, mutual fund managers (the good ones) are able to beat the market by about 1-2%, or the cost of their fees, so it should make no difference whether you invest in passive ETFs or actively-managed mutual funds.
The debate between passive and active investing isn’t necessarily a debate between traditional and robo-advisors. Good full-service financial advisors are able to recommend either mutual funds or ETFs and can set up the account either with embedded or transparent fees.
There is value in some of the services that robo-advisors don’t offer. Their cost ranges from a high of 0.7% on a small portfolio (under $100,000) to a low of 0.3% on large portfolios of $1,000,000. I don’t believe this includes trading fees. On average, this is about half the price you would pay a full service advisor, for about half the service offering. A few examples of additional services that a traditional advisor can offer include greater personalisation of investments (ethical investing, access to gold, betting on the outlook for China, etc.), financial planning, tax efficiency, hand-holding during bear markets and more. There is no such thing as a free lunch.
Having said that, a robo-advisor could be a good way to start. Make sure you get what you pay for (don’t overpay a full-service advisor) and that you’re willing to pay for what you get (don’t ignore financial planning and personalized advice). Just don’t be misled by the marketing and keep in mind that you can get the same service from a risk-profile questionnaire and a mutual fund or ETF at your bank.