[ Continued from Thoughts On The Recent Robo-Investing Saga (Part 1 of 2) ]
So what can we expect from Robo-Advisor (realistically)
Note that the following points are not made in reference to any specific robo-advisors but are generally the case for the majority of them.
1. Understand how robos operate and what asset allocation really means
Robo advisors create a passive portfolio of ETFs that is deemed to be suitable for the investor purely on the basis of his risk tolerance (mainly this), investment time horizon and financial objectives. This is in fact pretty much the same manner a physical financial advisor is supposed to run through with their clients through a process commonly termed as fact-finding or know-your-client.
These are helpful information for the robo or human advisor to decide if you are able to stomach more equities (as opposed to bonds) with higher volatility that may only have meaningful results over the long term. The crafted portfolio will often be a bundle of low-cost ETFs (or unit trusts for some human financial advisors) which is supposed to be in line with your risk tolerance.
Individual stocks are almost never chosen because it gets tricky if that particular stock faces considerable drawdowns and too much work has to be done to justify why that “particular” stock was chosen. Should there be a broad market selloff, it is harder to fault a robo or human advisor as the portfolio is already vastly diversified within a geographical location or industry. It was a result of market-specific events on the broader scale, rather than anything to do with their stock picking abilities.
And once we are invested, these robo or human advisors have their own “proprietary” frameworks that are often merely trying to rebalance the portfolio according to your risk profile and actively reallocating so that it remains close to your target allocation. There isn’t exactly any magical “machine learning”, “Artificial Intelligence (A.I.)”, “high frequency trading (HFT) or any other “secret ingredient” to it however they wish to market it. There may indeed be exceptions, but for most cases there aren’t.
How it works is that for example, you have a balanced risk profile and the portfolio was initially allocated with say 50% equities and 50% bonds. After inception of the portfolio, the equities have greatly outperformed relative to the bonds. Needless to say, you will now have a greater weightage of equities in your portfolio as opposed to bonds now. But based on your risk profile, it should be a 50-50 allocation. What happens then is that in the rebalancing exercise, the robo will attempt to redeem some of the equities and buy into bonds so as to maintain the original allocation. Therefore should the equity markets decline later on, you will be facing lesser drawdowns and hence is befitting of your balanced risk profile.
Rebalancing seems a good idea in theory, but in practice it can go awry as well. If the underlying equities are not performing well and are facing a sustained downtrend, one would be doubling down on something that is going to go down further and selling on other things that are making money and still continuing their uptrend. This means that an investor is going against the momentum of the market and is essentially giving up some potential gains of a performing asset in order to buy into another asset that is going to continue to decline in the near term. The investor is caught in a double whammy situation where he enjoys less of the future upside and is made to suffer further with more downside pain. All for the purpose of “re-balancing” to be aligned to the risk profile. A more optimal way would be to re-allocate based on risk to reward using technical analysis but that is a topic for another day. (I know some of the investors by now will stop me right here and say that there is no way to predict where the markets are going. Yes, we cannot predict and we never try to. But we can make educated guesses with a higher than average probability by understanding market trends. You may google on how to read market trends to get a better idea. Or we may write something on this in the future too if there is enough interest.)
Which brings to my point that rebalancing your investment portfolio is merely an act of readjusting your portfolio allocation based on your risk profile and NOT an act of optimizing your portfolio returns based on risk-to-reward. (You can read this last sentence a few times to sink that into your head.) What is often only mentioned in mainstream media is that rebalancing helps to improve diversification and help to reduce your risks. An ideal scenario would be for example, an outperforming asset that has now been irrationally overpriced and sold in order to buy into another asset whose prices are beaten down for now that is poised to do well in the future as well.
But in practice, we do not usually get the above ideal scenario. On the flip side, returns can often be equally diluted for the purpose of being more diversified and having possible less drawdowns. While I can’t speak for all, in most cases, a robo-advisor buys or sells an asset for you for the sake of matching your risk profile. It is often less likely that because an asset was undervalued or overvalued, overbought or oversold. This means it is also possible to have a scenario where an undervalued asset that is still early in the uptrend to be sold prematurely because it has performed relatively well and to be bought into another one that is struggling and facing some further headwinds ahead.
Hence trying to meet the suggested asset allocation in your robo-advisory portfolio can be a double edged sword.
2. Robo-Advisors might not be timely enough
Another common feedback that investors who have invested for a few years in robo-advisors lament is that robo-advisors are slow to react to changing trends or market shocks such as Covid in 2020 and the recent China market correction. The ability to anticipate crashes or manage the portfolio well before things happen seems to be a wild claim as they put it.
It is likely that robo-advisors cannot be relied upon knowing what to do when faced with sudden market shocks or extraordinary events, which happen more often than we think they do. At the back end, in one way or another, the robos usually use technical indicators that are often lagging indicators in their decision making process. By the time the “signal” comes, it is no surprise that the market might have gone up or down considerably. Indicators help most when the trend takes a longer time to evolve and is less useful during quick rebounds or crashes. Such is the same for most investors who use technical analysis. It is in fact alright to have indicators that are laggingsomewhatbut it is not alright for some of these robos to plaster claims on their websites that purport to having such a “smart” algorithm that will help investors to take advantage of the market volatility in a speedy manner.
This is because robo-advisers often lack the human intuition to assess how grave a situation can be and cannot be relied on to make decisions quickly or reliably in a crisis. Imagine if today the headline news is the possibility of China invading Taiwan and knowing what happened to Russia, our investment thesis in KWEB can very well be invalidated in an instance which a robo-adviser will not be able to make sense out of it till it really reflects in the stock prices after a few weeks. Not all crashes are equal. There are some that we know logically will bounce back quickly in the near term, and there are some that we know it is not going to happen anytime soon. It is usually a human investor, if at all, that will be able to differentiate if a crash is a result of the deteriorating industry fundamentals or that it is a broad based crash due to external factors such as covid-19 which can be solvable eventually.
This said, we respect thatthe team behind the robo-advisor actually took a step forward and intervened manually to liquidate the holdings this time round. Typically the robos would be left alone to do what they should do. Perhaps they may have acknowledged somewhat that the robos cannot be relied upon in situations like this to make a call. While we may not be on the same page based on the assumptions they had, we are saying that the action for them to intervene manually is a correct one in such a situation.
3. Robo-Advisors may not necessarily be cost-efficient
Different robos charge differently but generally it is a percentage of the assets that you have with them. Typically the management fee can be between 0.4%-0.7%. But to be fair, what makes something cheap or expensive can only be understood in the context of the value added. For the most part, the underlying are very commonly known ETFs that they are allocating into which you can easily have access to with other brokers. What is left next is the automatic process of rebalancing on a regular basis which does not take a lot of effort actually to be done on your own. Do not confuse rebalancing with active management. The former is merely an automated exercise with passive indexing strategies to maintain the original asset allocation while the latter is more of taking advantage of short term opportunities and mitigating losses proactively. Robos for the most part are merely rebalancing.
Let us do the sums. If taking 0.5% management fee out of a $10K initial portfolio with $1K top up every month over 20 years, with compounding effect, it is at least about $30-40K fees to be paid and that is excluding the fees that the ETFs charge too. Some investors start with a bigger initial outlay or do bigger regular top ups. The amount paid in management fees can be very considerable indeed, all in the name of being hassle-free. So you have to decide for yourself as an investor if the price of such automation is acceptable for you.
These are some points that you may wish to take note of when having a robo-adviser in your investment journey. We would like to re-emphasize the fact that these are some general pointers for thought without specific reference to any robos and some of them might have an exception to what is usually the case.
Better late than never
For those investors who have been forced to sell off their KWEB holdings, not all is lost. After all, the only ones who get hurt on the roller coaster are the ones who jump off in the middle of the ride. If you are still bullish on China and especially its tech sector that KWEB is primarily focused on, you can always take your money and buy into KWEB with another broker. As an investor, you always have a choice with the plethora of discount brokers these days. The only thing is of course you would have missed out on the gains in between for now.
Finding the best way forward
Understand that by appointing another party to manage your investments, they are essentially given the right to make some sort of discretionary investing decisions for you most of the time. This is what you signed up for. In the normal course of things over the long term, most ETFs selected by robo-advisors should stand a good chance of doing well. But in the short term, we never say never in the financial markets. Irrational exuberance happens from time to time and it is something that we believe is a challenge for robo-advisors to calm their investors down when things take a turn.
It is however worrying to read that some investors have commented on jumping ship to other robo-advisors in light of this saga. The same thing is going to play out eventually with other robo-advisors if they still do not understand and accept what a robo-advisor can or cannot do.
Perhaps the more important takeaway is to understand that everything is a business. There is no free lunch in the world. Investment trainers teach and charge a course fee so that the student can eventually learn to fish for themselves. The robo advisor or financial planner manages your portfolio in order to provide greater convenience in return for a wrap/management fee. That is all their value proposition.
But if you believe that you can do better, then you should learn to manage your own investments. The price you pay would be the cost of the time taken and financial mistakes to be made in order to get you to where you need to be. In one way or another, you will be spending some time or money in order to learn, purely with the hope of becoming better one day.
We welcome further comments or feedback below should there be areas that we may have overlooked and feel free to share this article to those whom you feel may benefit from it.
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