Automated portfolio allocation systems delivered no tangible benefit when the market melted down. Learn from their mistakes and earn your fees.
The first quarter was a nightmare for almost everyone who depends on index funds and their random walk. But most robo advisors did even worse – despite their claims to smart diversification and active rebalancing.
The numbers Backend Benchmarking collected speak for themselves, with the universe of 60 automated portfolios lagging a relatively simple allocation by about 80 basis points.
Factor out fees and the performance gap gets even worse. And that’s only the average: high-profile portfolios from people like Morgan Stanley, Schwab and Wells Fargo did 2-4% worse than the market as a whole.
When the market is soaring, investors will forgive a little drag because they know you’re covering their downside. But when the bottom drops out and that downside protection fails, they have a right to be angry.
Paying for discipline
At the end of the day, robo clients paid their fees to make sure the platform would prevent the worst retail investor impulses.
Instead of their assets simply pouring into U.S. stock index funds, some thought goes to diversification.
There’s generally an allocation to foreign equity and some attention to fixed income. As a result, these investors dodged what would have otherwise been a stark 20% S&P 500 decline over the crash quarter.
But that’s as far as the downside protection went. A vanilla 60/40 equity/bond portfolio built out of off-the-shelf ETFs dropped 13.4% in the period and after fees the typical robo account shrank 14.5%.
While a handful of platforms beat the benchmark by a few basis points, dodging the entire market bullet felt more like luck than discipline.
Robos that market themselves to socially conscious investors, for example, did relatively well, but it’s not hard to see a strategy that screens out oil companies and their debt evading a huge pain point.
Oil stocks crashed 40% in the quarter. Everything else being equal, a truly “green” portfolio outperformed the S&P 500 by about 1.2%.
That’s not really a repeatable win driven by smarter managers or better insight. It’s simply people who wanted to invest in a sustainable world dodging another oil bust.
And it reflects the somewhat random distribution of results. None of these portfolios have a long track record under anything but ideal market conditions.
Some gave investors a slightly better experience. Others took the money and delivered worse results.
Turning robo fee drag into a fee window
Until some programmer builds a better mousetrap, it’s all more or less a random walk. If you want that, just buy a stock fund and a bond fund and you’ll do about as well, without quite so much fee drag.
Conventional advisors provide value in exchange for the fees we charge. These numbers make it clear that retail investors could pay at least 1% a year for a human envelope around vanilla ETFs without any material impact.
All we need to do is communicate that value while preserving our own operating margins. You can make unprofitable accounts too happy.
Solve that challenge to your own satisfaction and you can capture robo clients. Yes, the apps are cheap. But when you find a viable prospect, ask what they’re getting for their money.
Really sophisticated allocation bends with market conditions. A lot of conventional advisors had the discipline to pull the plug on equity when it was clear that we were headed into a crash.
Some relied on algorithmic tools just like the robos theoretically provide. Others simply read the wind and dumped risk assets early in the drop.
You know the psychology. A lot of investors are willing to surrender a little upside in order to avoid appreciable downside. They don’t want to lose what they have.
Stop loss thresholds were invented for a reason. Investors who need to keep income flowing and satisfy their Monte Carlo assumptions benefit from maintaining a certain efficient frontier.
Sometimes the market twists those assumptions. Black swans are real. When historical stress testing suggests better short-term survivability and long-term results, the portfolio needs to twist with the times.
Ironically enough the robos don’t take advantage of their high-tech environments. Vanguard’s Digital Advisor apparently didn’t rebalance at all over the quarter.
I’d love to see data on whether more frequent rebalancing helps these platforms hit their targets. Obviously there’s an efficiency tradeoff here, but again, the numbers will reveal what makes sense.
I remember when annual rebalancing was considered a little exotic, the secret of legendary Ivy League endowments. Now the right kind of account can adjust monthly, weekly or after every big day.
And tax drag adds up faster for active traders, which opens up opportunities for real tax-efficient solutions to demonstrate real performance benefits.
A lot of this still revolves around client-specific choices in order to weigh when a trade makes a difference (good or bad) in the larger tax framework. If you don’t know what an individual client needs, you’re really just guessing.
Guesswork is the stuff of robots. One-size solutions fit many but not all. Personal attention is worth an added fee for many.
It all comes back to account size and the investor’s priorities. Most people will surrender about 1% of market return in pursuit of discipline, insight and convenience.
That’s a fact of human psychology. We even see it with the robos, where investors can see the gap between performance and the benchmark and pay the fee anyway.
They’re paying that fee for comfort. If you can provide similar or better levels of comfort, you can confidently charge as much.
And if you can at least hit the benchmark, you can charge a whole lot more. Robo is leaving money on the table for a reason.
They aren’t confident they can charge more for the service they provide. Admittedly, there isn’t a lot of profit in 0.30% but at the right scale, it can happen.
Vanguard has shifted $148 billion to its Personal Advisor program, opening up $148 million in additional fees for the advisors monitoring the accounts to share.
Getting notoriously independent-minded investors to cough up even 0.10% extra for outside guidance is an achievement. If your prospects want more support, they’ll happily pay.
We talk about this a lot. I think fee compression is real because as we all get more efficient our internal costs drop and we don’t need to charge as much.
But the threat is exaggerated. Robo can survive on a proposition that gets investors to pay about 0.30% for the privilege of giving up about 0.80% of benchmark return capture.
We’ll talk more in the future about why they lag and how you can do better.