The future of Robo Advisors and financial advice. [Part 2]

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Part 2: What does Good Financial Advice Actually Look like?

From my past blog post which you can read here, it may seem like I am uniformly negative about Robos. Not true. Here are some things that Robos have gotten right:

1) Price point: Low fees and generally no minimum balances are a clear plus. 0.25% charged by a Robo is obviously a better price for investing a client’s assets than the 1–1.5% typically charged by a human advisor. The human advisor also typically requires a very large minimum amount to manage -in the hundreds of thousands of dollars or more.

2) Investment Simplicity:

a. Passive vs. Active Portfolios: There is evidence that passive strategies result in greater returns to investors over time. In many instances, this won’t be the recommendation to investors from human advisors, because it runs counter to the profitability model of the company giving the advice. Warren Buffet’s commentary in Berkshire Hathaway’s 2016 annual report elaborates on this, and summarizes with “The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”

b. Basic Risk Questionnaire and Rebalancing: Although relatively simplistic, and with no ability to update or learn more about a client, Robos do attempt to assign a risk preference to a client. In addition, on a quarterly basis, most Robo’s will automatically rebalance the client’s portfolio to get it back to the original fixed risk level assigned to the client.

c. Tax optimization: Robos will often provide tax optimized portfolio strategies.

3) Data ownership: Robos are pushing for investors to own their own data rather than having it owned by banks. This has potentially far reaching and positive effects for consumers in general. The European regulators are farther along on implementing this than are the US regulators-in the form of the PSD2 reforms. It is patently ridiculous that consumers not be in control of their own data and information. It would be as if a doctor owned your medical records and you were unable to access them or share them with another doctor.

So, thanks to the Robo industry, there are some advances that the broader population will benefit from. However, here are some things that Robos don’t do which call into question their effectiveness in managing a passive investment portfolio:

1) Robos typically don’t adapt their investment allocation strategies. Markets change. Clients’ priorities change. Liquidity needs and the ability to take risk change. Shouldn’t the allocation of the assets in your portfolio also change?

2) Many use simplistic investment models based solely on Modern Portfolio Theory conceived in the 1950’s, which don’t adjust as the market conditions change, resulting in investment decisions that are sub-par, as they don’t take into account newly available market information.

3) They often don’t incorporate top quality analysis for the market outlook incorporated in their modeling. What is their source of the projections and are they best in class?

4) Although the price for Robo’s is typically low, if not viewed in the context of returns it is impossible to evaluate- and this is not always transparent. To be clear, a minimum charge of $1/month seems insignificant, but is it inexpensive if the portfolio is expected to return $.50/month? $1.00/month? $10/month?

Far more important, however, how does a Robo tell you which investments are right for you?

1. Fiduciary duty vs. low cost duty: Robos are generally low cost, no doubt about that, but that does not mean they are fiduciary. Getting the wrong advice can be very costly. A Robo-advisor, is not an advisor, as they are unable to understand a client’s financial situation comprehensively — they are fundamentally not capable of providing fiduciary advice.

2. The Massachusetts Securities Division put out a very strong statement as to their concerns about Robos not being fiduciary. They said the following:

“The Division believes that currently Robo-advisors cannot satisfy their fiduciary duties because they fail to perform initial and ongoing due diligence to act in the clients’ best interest.” A very strong statement, but worth examining closely when considering how and where to get investment advice. Federal Agencies have expressed similar concerns, with both the DOL and the SEC weighing in on the subject.

3. Robos have a lot of fine print. Much of it amounts to saying, “we don’t have to look out for you”. One leading Robo says that it is “… not responsible to Client for any failures, delays and/or interruptions in the timely or proper execution of trades or any other trading instructions placed by [Robo] on behalf of Client through [Robo’s broker dealer] due to any reason or no reason.” Any reason or no reason? That doesn’t really seem like a very high standard of care. Of course, you would have to read up to page 23 in their 48-page disclosure document to get to that.

What is good fiduciary advice? That is pretty simple (see my recent SEC submission on that topic here). It is advice in the best interest of a client. It is knowing the client well enough to give them the advice they need — even if that means telling them they should not invest right now. It is being a fiduciary- putting the clients’ interests ahead of the advisor’s interests. It is having no conflicts of interest. In short, it is something that is very difficult for a Robo to achieve.

It reminds me about a saying on trust, “Trust takes years to build, seconds to break, and forever to repair”. With clients, there is an opportunity to build trust in giving sound and fiduciary advice- handling that carelessly may not be recoverable.

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Catherine Flax, CEO Pefin

Jay Gopalakrishnan