Robo Advice: Are ETFs the Solution?

This article was first published at the CFA Institute.

Robo advice is a hot topic — both the term itself and the future it represents.

Robo advice describes online, self-led investment propositions. It was developed in the United States by such start-ups as Wealthfront and Betterment, among others, that have since been followed by entrepreneurial start-ups and replicators throughout the world.

The market for robo advice is growing rapidly, particularly in the United States and Europe, and many anticipate that most savers and investors will be using robo services within the next decade.

More than five years after robo-advisers emerged, almost 100% of their assets under management (AUM) consists of narrow portfolios composed of exchange-traded-funds (ETFs).

This will change as automated processes are developed that can invest in a wide array of funds, both ETFs and individual securities.

RiskSave and True Link are examples of such emerging technology. The portfolios generated from a broader spectrum of assets improve on the current robo model, offering more efficiency and superior risk-return characteristics.

Unfortunately, the ascent of robo advice concerns some advisers who believe the technology is a poor substitute for personal advice and individualized recommendations based on expert knowledge. They also may see it as a threat to their livelihoods.

For all but the wealthiest clients, the traditional face-to-face business model of financial advice will probably be disintermediated. But as much as robo technology represents a challenge for advisers, it is also an opportunity to better engage clients with more detailed, frequent, and accurate reporting. Robo advice will help advisers streamline their processes, giving them more time for marketing and developing a superior customer experience.

Robo advice and digital asset management will open up financial advice to a much wider market. People who previously were priced out of financial advice will now be able to afford it. The reduced costs of robo advice in the United Kingdom could give as many as 16 million more people access to financial advice, according to estimates from the Financial Conduct Authority (FCA).

But the robo model has more than just potential mass-market appeal, it also has regulatory support. Governments are encouraging the growth of digital asset managers in order to increase financial inclusion and eliminate the financial advice gap. In contrast to pricey human advisers, low-cost robo-advisers will give clients with less capital a greater selection of savings and investment options. After the initial onboarding, the robo service requires minimal intervention and has a permanently low-cost base.

Of course, the current crop of robo-advisers has lowered costs by trading ETFs as a proxy for the universe of investable assets. ETFs are much cheaper than traditional funds but still mitigate the idiosyncratic risk of individual securities through diversification. If one security in the basket underperforms, the effect on the portfolio’s performance should be relatively small.

While new research and technologies are promising and constitute an improvement on current processes, they are only the first step.

Are ETFs the correct solution?

Much of the financial management industry has concluded that ETFs are the future of automated advice. That is naive.

The goal of automation and technology is greater precision. The investment universe of individual securities can better provide that than ETFs. This wider domain will reduce risk and increase expected returns. It also can help save on fees. A wider universe is, by definition, of equal or greater efficiency. It is a case of having your cake and eating it, too.

When equity risk is the focus of robo advice, ETFs work reasonably well. They are a cheap way to access a diversified portfolio. But as the inevitable reweighting toward fixed income occurs, there is an assumption that integrating fixed-income ETFs into the mix will be easy. This too is naive. Instead of relying on a package of liquid managed funds or ETFs to provide fixed-income exposure, a more advanced robo-adviser should move to individual securities.

Otherwise, ETFs used in this way will probably:

• Underperform their index.
• Force a one-size-fits-all risk/return profile on customers.
• Be the next collateralized debt obligation (CDO) risk.

In a market shock, investors want their fixed-income exposure to provide a safe haven. But there is no guarantee, nor any reason to expect that liquidity providers will continue to support ETFs. This could lead to underperformance at a time when the hedging effects of fixed income are supposed to protect investors.

More intelligent portfolios can help investors avoid these hidden pitfalls and make alpha more attainable. By moving beyond ETFs, robo-advisers can help hedge against black swans and reduce systemic risk.