Silicon Valley, the epicenter of so-many startups, and the place where I spent most of the last ten years, has a way of speech that takes some getting used to.
In a land where so many big ideas are seemingly constantly swirling, it’s not enough to start a company that offers a respectable good or service that is incrementally better than the competition, you have to be “disrupting” some giant industry, ideally in a way that utilizes “robots”, “artificial intelligence”, and “software eating the world” and “big data.” It takes some work to piece out the ideas that are truly world-changing from the ones that tilt more towards marketing hype.
Enter “robo-advisors”, a new breed of wealth management firm which will supposedly replace human money managers with software that is smarter, cheaper, and less prone to making emotional mistakes. Proponents say that these firms are “democratizing wealth management” by making strategies previously accessible only to the ultra-wealthy available to anyone.
But just what is a “robo” money-manager? Turns out that is not so simple of a question to answer.
By drawing analogies to other spaces in which “Big Data” and “Artificial Intelligence” are taking hold, you might assume that a robo money manager would resemble the world of algorithmic trading, in which highly sophisticated software scours the market constantly for micro-inefficiencies that large hedge-funds can take advantage of by placing trades that are often times unwound within seconds or minutes for a quick profit.
Or you might think that “robo-advising” must be about the growing movement towards alternative datasets, a trend where sophisticated hedge funds acquire data such as movements of people as tracked by their mobile phone apps with background permissions enabled, then triangulate this against lat-long maps of the US and from this infer whether Target is going to beat their fourth-quarter earnings estimates or not based on how many people are frequenting Target shops. This is truly high-tech big data stuff.
But in fact what the practitioners of robo-investing mean is not really either of these things. Robo-advisors are (with recent limited exceptions that we will talk about) focused on passive investing, not actively trying to beat the market.
This is somewhat ironic because although “robo-advice” is a relatively new turn-of-a-phrase, the very foundation of the modern roboadvisors – the humble index fund – is in some ways the first example of “robo-advice.” An index fund is a mutual fund or ETF that follows an automated and software-based procedure for selecting investments: in brief it buys every stock in a particular region or sector in proportion to the stock’s overall market capitalization. Thus one “set-it-and-forget-it” “software-based” and low-expense way to manage your money is: buy a Vanguard total stock market index fund, invest a bit more every month, and forget about it until the day you retire. This primitive “robo-strategy” results in sub-optimal diversification due to concentrating all your assets – but you could do worse (most people DO do worse).
A step-up in sophistication is the Retirement-Date Mutual Fund, which due to their status as the default choice in many 401K programs, have grown quite popular. These are “funds-of-funds” that allocate across underlying index funds to build a more balanced portfolio, and then adjust the composition of this portfolio to get more conservative as the investor approaches his or her retirement date. This gives rise to perhaps the second era of robo-investing: buy a Retirement Date mutual fund and forget about it until the day that you retire. Our comment here would be similar to above: we find this a sub-optimal strategy because 1) It does nothing to protect an investor’s capital from manias and crashes, and 2) (as we wrote about last newsletter) the evidence that shifting into bonds as you age improves actual financial outcomes is non-existent. But again – one could do far worse. Buying a Vanguard Retirement Date Fund, investing monthly, and forgetting about it until you retire is a recipe to almost for sure outperform the average investor.
This brings us to the subject of this newsletter: the latest “roboadvisors” that purport to disrupt the world of investing. These services have proliferated in the last five years, but we will concentrate here on two of the original: Wealthfront (based in Palo Alto) and Betterment (based in New York).
So how do these services use robots to transform the world of investing?
Like IvyVest, both Wealthfront and Betterment believe in passive investing (index funds) and in diversification. They invest in low cost exchange trade funds (ETFs) and diversify over U.S. stocks, foreign stocks, U.S. bonds, and foreign bonds. Wealthfront also breaks out dividend stocks and natural resource stocks as separate categories. Betterment tilts their portfolios towards value stocks by putting a portion of their portfolios in Vanguard ETFs that track “value” indexes (value stocks are defined as stocks with lower than average price to earnings ratios). There is historical evidence that high dividend stocks and low price to earnings stocks outperform the market as a whole.
One way these services are “disruptive” to financial advisors is certainly that their fees are much lower than what is charged by most traditional advisors. Both Wealthfront and Betterment charge 0.25% of assets under management, but Wealthfront will manage the first $15,000 for free. Betterment also has a premium service that gives more personal contact and costs 0.40%. Of course these fees are on top of the fees of the underlying ETFs that the robo-advisors will put your money in, so strictly-speaking robo-advisors are actually an in-between option that is more expensive than managing your money on your own (which could be as simple as buying the same ETFs that the services would put you in) and hiring a full-fledged financial advisor.
Thus far, it doesn’t seem that the “robo” in “robo-advisor” is doing that much that a smart mutual fund rule couldn’t do, for less in fees. Of course a difference is that roboadvisors construct allocations on the individual level rather than pooled with other customers as they would be
I) Personalized Asset Allocations across accounts
A mutual fund by necessity must invest the same way for all of its fund owners. Robo-advisors could in theory invest differently for each subscriber. In practice, they still tend to segment users into a small set of groups. Wealthfront uses an assessment of your risk tolerance to determine the distribution of funds across the asset categories. Betterment does this by your age (which is not so different actually than a retirement-date fund).
II) Automated rebalancing
The next way that robo advisors can automate the investing process is by automatically rebalancing your account for you when markets move, so that you always stay within range of the right asset allocation. In practice, minus the other two items on the list, this is in itself not so different from target-date funds which also do this. But robo-advisors can manage it across the different accounts that you have managed with them.
III) Tax-Loss Harvesting
Both Betterment and Wealthfront will perform tax lost harvesting on your account. So what is tax lost harvesting? It involves selling assets that have fallen in value and replacing them with very similar assets. For instance, if there is a market downturn, you might sell the Vanguard Total Stock Market ETF (VTI) and buy the Schwab U.S. Broad Market ETF (SCHB). These two funds can be expected to perform in a similar manner, so you wouldn’t really be altering your portfolio, but you could use to tax loss on VTI to cancel out gains elsewhere in your portfolio. Also, you can use up to $3000 of losses in any one year to offset some of your regular (not capital gain) income, and you can carry forward to future years the losses that aren’t used. You can do tax loss harvesting yourself, but you must keep track of the tax cost of every block of stock that you buy. An online broker will keep the records for you, but you will need to decide what specific block of stock to sell when you want to do tax lost harvesting. Having Betterment or Wealthfront decide when and how to do the harvesting is probably a real advantage. Of course, you should realize that tax loss harvesting can only applied to taxable accounts. It is not applicable with IRAs or 401Ks.
So how valuable is tax-loss harvesting? It is a bit difficult to generalize, because it depends on market conditions, your tax rate, and the time that you will hold the investment. It is important to remember that the tax you avoid by tax lost harvesting is really a tax that is delayed, but not avoided entirely. When you do tax lost harvesting, your tax basis goes down, so the tax you must pay when you finally sell your investment goes up. This is true unless you donate the assets to charity or die before selling. In the latter case, you heirs will get an automatic step up in the tax basis.
On their website, Wealthfront suggests that tax lost harvesting can realize a savings of $1550 per year on a $100,000 account. We suspect that this estimate is too high for most situations. ETFs rarely declare capital gain distributions. To our knowledge, no Vanguard ETF has ever declared a capital gain dividend except in the first year of operation. So, if your portfolio is invested in ETFs, and if you don’t sell anything, you shouldn’t have any capital gains to offset.
Of course, the act of rebalancing your portfolio might generate capital gains, and tax loss harvesting could be useful in this case. If you don’t have capital gains to offset, then the benefit of tax loss harvesting will be limited to the $3000 dollars you can use to offset regular income. If your combined federal and state tax rate is 35%, this benefit could be worth $1050 per year. However, we must state again that this is really tax deferred, not tax avoided. There is certainly an advantage to tax deferral (that’s why we have IRAs and 401Ks), but the size of the benefit depends on how long you hold the investment. Also, the opportunity for tax loss harvesting will largely be during market downturns. In many years, there may be no good opportunity. While we think Wealthfront may be over estimating the benefits of tax loss harvesting, we agree that it is a very useful feature to their accounts.
IV) Direct Indexing
Wealthfront offers another feature, called Direct Indexing, that affects tax loss harvesting and can reduce costs. Direct Indexing is available for accounts that hold $100,000 or more. For these accounts, Wealthfront will eliminate the index funds and invest your money directly in a portfolio of 1000 stocks (or in some cases, 500 stocks plus an ETF for small cap stocks). Each stock is held in your name, not as part of a fund. The 500 or 1000 stock portfolio duplicates the performance of the ETFs that would otherwise be used and eliminates the ETF management fee. This service is only available for the U.S. stock portion of your portfolio. The management fee on Vanguard ETFs is very low (the fee for VTI is 0.04% and the average for all Vanguard ETFs is 0.09%), so the gain from eliminating fees is small. However, Direct Indexing opens up many more opportunities for tax loss harvesting, since even in an up market some individual stocks will be down. Of course, this can make your tax return much more complex, but Wealthfront will send you a 1099 form. Note that there are “tax-efficient” mutual funds that attempt to do similar things.
V) “Smart” Beta Investing
Another feature offered by Wealthfront is what they call Advanced Indexing. It is available for accounts of $500,000 or more. It attempts to increase returns above level of the general market by using “smart beta” concepts. Our newsletter for November, 2016, dealt with smart beta, and you might want to take a look at that newsletter. Smart beta attempts to identify general characteristics of stocks that have outperformed the market in the past. For instance, value stocks (stocks with lower price to earnings ratios) have outperformed in the past, and this is one of the factors considered. Other factors are dividends (stocks paying higher dividends have outperformed in the past), momentum, and volatility). By directing money towards stocks that score high on these criteria, Wealthfront attempts to beat the market. Other mutual funds and ETFs are also trying to do this. While the track record is short, some of the smart beta funds appear to be having some success. However, as more people pile into this arena, the advantages may disappear. Time will tell.
At IvyVest, we have always argued that the world of financial advice is and has been in dire need of change. For too long, people’s choices in the world of financial advice have amounted to bad or worse. Bad: giving money to a Registered Investment Advisor who pockets 1% of your assets a year and then turns around and puts you in a simple diversified portfolio you could have bought yourself for nothing. Worse: giving money to a broker who turns around and buys the (likely poor-performing) actively managed mutual fund that pays him (or her, but likely him) the highest kickback in the form of a commission.
Wealthfront and Betterment deserve credit for providing another alternative to people who do not want to manage their own money. But their rhetoric goes a little too far. The root-cause of financial problems is investor behaviors, not investment products. It is not true that only the wealthy have access to good products, or even good advice. Good financial products exist today, and they exist in spades. We should celebrate that through companies like Vanguard, you can now buy a fund that will give you exposure not just to the US stock market, but to the entire global stock market, for fractions of a cent on the dollar.
Robo-advisors like Wealthfront and Betterment may seem disruptive when compared to human financial advisors, but actually they are less-so than are index funds and asset-allocation mutual funds. When compared to these options, the main advantage Wealthfront and Betterment can point to is tax-loss harvesting. For those with sizeable taxable accounts (tax-loss harvesting offers no advantages for IRAs or 401ks) the services may make sense on that basis. But view them for what they are – an incrementally better option than what existed before for some categories of investors, not a new paradigm of wealth management.
Do-it-yourself investors that want to manage their own money can carry-on carrying-on. The thing that truly “disrupted” investing forever was the index fund (especially as implemented in ETFs), not Wealthfront or Betterment.
One may ask how Wealthfront and Betterment differ from IvyVest. Unlike IvyVest, Wealthfront and Betterment accept money for management. That is, they accept your funds, invest them according to their best judgement, keep records, and manage chores such as rebalancing and tax lost harvesting. They will handle rebalancing and tax loss harvesting. They do the work of managing the account. IvyVest gives you advice, but you have to establish an account with a discount broker and initiate the trades yourself. IvyVest will tell you when it is time to rebalance and how many shares of which security to buy and sell, but you have to initiate the trades yourself. If you’re going to do tax loss harvesting, you have to decide what to sell and when to sell yourself. Some people will undoubtedly be more comfortable if someone else handles these chores, but you pay 0.25% for this service (which can add up for a large account).
In general, we have always believed it is better for you to keep your funds in your own name. This reduces costs and eliminates the possibility of fraud (where a financial advisor takes your money and sends you false statements). Fraud in the financial services business is rare, but it does happen We think the possibility of fraud with these companies is very remote, but there are other reasons to manage your personal finances as well: it keeps you in control, it’s educational, and it avoids conflicts of interests that so-often occur in the industry.
Like Wealthfront and Betterment, IvyVest recommends passive investments and diverse holdings. IvyVest recommends even greater diversity, because we put a portion of our recommended portfolio into domestic and foreign REITs, commodities, and gold. We think the greater diversity may be helpful during downturns in the markets. Like Weathfront and Betterment, IvyVest recommends low cost ETFs, principally Vanguard ETFs.
A major difference is that the IvyVest portfolio is dynamic. The distribution of funds across the asset classes changes based on market conditions. Our algorithm, based on historical market performance, moves funds between asset classes based on value and momentum criteria. Using historical data as a guide, it attempts to move out of relatively overpriced assets and into relatively underpriced assets, and by doing this it attempts to avoid bubbles. Wealthfront and Betterment have static portfolios. Back testing shows that the IvyVest algorithm would have significantly mitigated losses in the last market downturn. We think it will mitigate problems in the next downturn as well.
In short, if you like to do-it-yourself and you want a strategy that will protect you from the next bear market, IvyVest is a good option. If you prefer someone to do it for you, robo-advisors may be worth a look, or you may prefer to keep it simple and buy a mutual fund with diversity and re-balancing built into it (such as a balanced fund or retirement date fund). If you take the last option, be sure to look at the management cost of the fund. You should keep the cost below 0.25%, and you can do that with Vanguard retirement date funds, which have an average fee of 0.13%. There are also other low cost options, such as the Blackrock “Life Path” funds.
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