What Robo Advisors Get Right, and What They Get Wrong.

I like to use questions that I receive from clients to help come up with ideas to write about because if one person is asking the question, I'd be willing to bet that they're not the only person who is thinking about it.  I recently got asked about all of the commercials and articles that have recently come out in regards to robo advisors and self directed passive investing.  There seems to be a lot of good reasons to invest without an advisor, the most important reason being saving on costs.  But does this actually translate to a better result for the investor? You might be surprised to learn that I think robo advisors are a tremendous innovation which will add a lot of value to many people in investing.

I've spent a lot of time thinking about our industry and about the various types of investments and I won't dispute at all that the types of things that robo advisors and passive investments are doing are addressing real problems with the investment industry as it currently exists.  There have been criticisms that some advisors overcharge their clients and don't provide enough value in terms of outperformance on the investments, or on providing helpful wealth management advice to help clients plan for their future.

Mutual Fund Industry

In terms of pure market performance, it is true that less than 10% of mutual funds or other active managers will consistently beat their benchmark index over time. (Common Sense on Mutual Funds, John C. Bogle). This is largely due to the costs associated with active management. There are however some structural issues with the mutual fund industry which also help lead to their underperformance: Mutual funds are not necessarily designed for the best performance. They are products and the fund company makes more money if they sell them to as many people as possible.  Some fund companies are better at capping their funds and looking out for the best interests of investors, but there are some companies who are not as good at this.

This means that many mutual funds are launched AFTER an investment boom has taken place in a given sector. For example, it was only after a number of cannabis related stocks took off that mutual fund companies started packaging together cannabis themed ETFs and Mutual funds. This is because the investors tend to pile into an investment trend after it's already happened, and fund companies might react to this by creating products after its often too late to benefit from that trend.

Another structural problem with mutual funds is the need for cash liquidity on daily redemptions. Because a mutual fund can be redeemed at any time, the manager must set aside a certain portion of the portfolio in cash to fund those redemptions. This cash acts as a drag on portfolio performance over time, whereas an index especially would have no cash drag.

It's an even bigger problem than that however because market psychology of investors always shows that when performance is good the manager will get a lot of investment into the fund which provides the manager with a huge pile of cash to invest at the exact time when good investment opportunities are probably getting scarce. Conversely, when the market is bad and there are many good investment opportunities because of the drop in prices, that is exactly when people pull their money from funds and prevent the manager from taking advantage of those opportunities.

Yet another structural problem with mutual funds is how the managers themselves get compensated, and how they can be fired. Many mutual funds don't try to be too aggressive and to look too different than the benchmark they are competing with. Often they do this subconsciously and may not even be aware that they're doing it. The reason they do this is because being different comes with more risk of potentially underperforming.  If they look too different and underperform then they might lose their job.  If their fund is different and the opposite happens and they outperform the benchmark, then they will most likely only get a modest bump in compensation. Therefore, the risk of underperforming versus outperforming is not balanced. Hence, there's a lack of incentive to manage the fund differently.

Despite all of these things that robo advisors and self directed companies get right, there are a lot of things they also get wrong: They fail to mention that while Mutual Funds have structural problems, ETFs and index funds also have structural problems which are often not well understood. There are many different types of indexes and it is a full time job to manage which index you should buy.

Example

For example you could buy just a simple TSX Composite Index with the lowest fee, but you would actually probably be better off buying an S&P TSX composite Index fund which is either equal weighted or value weighted as opposed to the usual market weighted. The reason for this is that market weighted indexes by definition overweight the most expensive stocks. This creates a structural problem where you are overinvested in expensive stocks and under invested in inexpensive stocks. Because of this, market weighted indexes actually underperform their benchmarks by a wide margin a lot of the time, and sometimes do even worse than a comparable actively managed fund after fees.

Some of these funds also have high turnover due to how they're structured, and this can lead to higher transaction costs and taxes. So complexity is definitely still an issue even if you're going to buy index funds. I think for most clients, they simply don't have the time necessary to familiarize themselves with the different options as other parts of their life are a higher priority.

ETFs

When robo advisors or other passive investors do comparisons with actively managed funds, they always compare the actively managed fund to the index itself, like the TSX Composite or the S&P 500. This isn't a fair comparison though because you can't actually invest in those indexes. You can only invest in an ETF which tries to mimic the performance of those indexes. Though these ETFs can come close, there is always going to be tracking error and costs of managing the ETF which will lower the performance of the ETF.

Sometimes these costs can be significant. When you factor in these extra costs, the comparison between actively managed funds and passively managed funds is a lot closer than they are portrayed. They also fail to mention that many studies have been done that show that investors with advisors do better than investors without advisors https://www.wealthprofessional.ca/market-talk/selfdirected-investors-do-better-with-advisors-says-report-251159.aspx.

The reason is because of human psychology. If you're investing part time on your own, you are going to be far more susceptible to market swings where you'll over invest in trendy investment ideas or during a market bubble and under invest less well known investments or at panic times when you should be doing the opposite.

Investors with Advisors Tend to Stay Invested More

Now most people think this won't apply to them.  They'll believe that they will act rationally when the time comes. Unfortunately for most investors the statistics simply don't bear that out. It can be very stressful and challenging to stay the course when you're in the middle of a market panic and especially so if it's something you're only watching on a part time basis. Investors with advisors tend to stay invested more often and they are less likely to gravitate towards the most recent investing trends, and for that reason they usually do better even after paying fees.

Perhaps most importantly of all, even though 90% of actively managed funds underperform there are still 10% of managers who do consistently outperform. Contrary to what passively managed fund people would want you to think, these outperformance people are not random and they're not a fluke (at least not all of them). Some of the ways you can identify these outperformers can be learned.  Warren Buffett spoke about this in the Superinvestors of Graham & Doddsville.  

The most successful investors subscribe to the mantra that when you invest you should look for value and try to invest with a margin of safety built into the investment. You do this by investing at a price far below the actual value you think its worth, so that even if you're wrong, you will be unlikely to lose money. The most successful investors invest for the long term and treat the investments as an ownership share in a business rather than just a piece of paper to be traded.

Prepare a Good Wealth Management Plan

Ultimately the most important thing you can do to improve your financial outlook is to prepare a good wealth management plan to identify your goals and objectives and then figure out how you're going to accomplish them.  This is far more important than your actual investment performance as either a passive or actively managed fund will work if you plan appropriately.  

Planning is an area where a real human advisor still has a huge advantage because they can get to know you and customize a plan to your specific circumstances, which is something a robo advisor will struggle to do even with today's technology. There are many good things about passive investments and robo advisors.  However they are not perfect and when you consider what would be best for you, its helpful to be aware of their shortfalls as well as their benefits.

- Craig White, BA, LL.B., CIM

Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.