Pitfalls of Robo-Investing Every Investor Should Know

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Automated investment services, often called robo-advisors, may spit out impressive algorithms, but can they totally replace human intuition and the nuances of sound investing? Probably not.

It’s 2016 and the winds of change are blowing in the investment industry. Despite  the fact that we live in a tech age, Charles Dickens’ A Tale of Two Cities seems apt: “It is the best of times, it is the worst of times, it is the age of wisdom, it is the age of foolishness …”

I’ve spent more than 30 years in the investment industry and based on that perspective, I believe Dickens’ sentiment best describes the situation many investors face today. There are too many choices, too many opinions, too many opportunities and too many potential pitfalls.

Last spring, a friend of mine, who is nearing retirement age, said jokingly, “Steve, have you heard about these robo-advisors? For ten bucks a month they will manage my investments, and I can do it all online.”

This revelation caused a flashback to the first time I heard a client tell me about online trading for $9.95 per trade. “Well, it sounds like a steal of a deal,” I quipped, “but remember, you usually end up getting what you pay for.”

At the same time, my friend’s comment piqued my curiosity. What are robo-advisors, and how do they operate? Who is their target market, and is their service suitable for the average investor?

Simply put, a robo-advisor is a hybrid financial institution that is one part discount broker and one part fee-based fund manager. For the right investor with the right temperament, robo-advisors might become a moving force in Canada’s financial-service arena. How big a force? Well, in fact, Canada’s six major banks are looking at the growing presence of robo-advisors as a potential threat to their traditional customer base.

The Rise of Robo-advisors
Right now, 80 per cent of the financial assets managed in this country are controlled by Canada’s six banks. They offer three competing business lines. For investors with assets in excess of six figures, there is a financial advisor who will provide advice and a full range of financial products for either a fee or a commission. For medium-sized clients, the banks offer “personal banking and business advisors” who are usually restricted to selling mutual funds and GICs. For the do-it-yourselfers, the banks offer online discount trading.

Unfortunately, rising administrative and regulatory costs are causing some financial firms to attach minimum fees and commissions to investment accounts, effectively stranding medium- and small-sized investors. These investors are either forced to pay unpalatable fees or seek alternate investment advice. Robo-advisors are positioning themselves to capture some of these disenfranchised investors.

How Do Robo-advisors Work?
As I understand it, the robo-advisor process starts with filling out an online account questionnaire. This is similar in nature to opening an online account at a discount firm. The next step in the process is to answer a series of questions designed to measure the investor’s investment return expectations (income and capital gains), risk tolerance, taxation issues, time horizons and liquidity needs. These questions have been designed using complex algorithms to capture psychological preferences. Unfortunately, I do not know if it is 20 questions or 120; regardless, once the questions have been answered, a portfolio of investments is created for the client. Some use Exchange Traded Funds (ETFs), some use mutual funds and some use both.

From there, the robo-advisory firm rebalances the client’s portfolio according to pre-established parameters. This is designed to make investors feel comfortable about their investment portfolios through market cycles without having to pay the fees that the full-service investment firms charge.

For example, an investor at a full-service investment firm with a $100,000 investment portfolio will likely be paying a minimum fee of $1,500 per year or commissions that average two per cent per transaction. That is a far cry from a robo-advisor that might be charging $10 per month, plus some low-rate administrative costs. Clearly, this will appeal to small- to medium-sized investors who are weary/wary of rising fees and expenses.

In my opinion, however, there are potential pitfalls:

1  Impersonal  First, when robo-advisors gather information from clients through online questionnaires, they may not assess all of the emotional issues that make each individual unique. Call me old-fashioned, but looking a person in the face when gathering new client information is critical in the investment-management process. Sometimes, for instance, clients don’t want to answer questions honestly. Perhaps their marital status is an issue, or maybe one of their adult children has an addiction issue. Will a robo-client feel comfortable putting that information online?

2  Market Stress  Will the client of a robo-advisor panic when markets go through volatile periods and run to cash in at the wrong time? Financial advisors often act as counsellors to steady their clients’ emotional reactions during times of market stress. We want our clients sleeping at night. It is our job to worry.

3  Changing Market  What is the track record of the algorithm program that is generating the asset allocation? The investor is putting faith in a computer program that is trying to operate under constantly changing market conditions. In my opinion, we are in the midst of a global deflationary investment cycle, something that has not been seen in over 80 years. So how can a computer program create an adequate model?

4  Unknown Attachments  Lastly, is the robo-advisor truly independent, or has it been created to market specific lines of mutual funds or ETFs? In April 2014, Power Financial made a $30 million investment in a robo-advisory firm. Power Financial also has ownership interests in Investors Group, Mackenzie Investments, London Life, Canada Life and Great West Life. I wonder which products will end up in those client accounts.

Think Twice
I think robo-advisors are here to stay in Canada. Yes, they may provide a leg up in service for the online do-it-yourselfer, and they may become a valid alternative for clients that are being dropped by full-service investment firms or for clients being transitioned to a call centre. However, I still believe that there are potential pitfalls when it comes to relying on a portfolio based on a computer-generated model.