Robo Advisor Rally In ETFs Has A Big Problem

October 30, 2014

With Schwab wading in, what’s not to love? Simplicity.

We reported earlier this week that Charles Schwab is the latest to enter the so-called robo-advisor space. This piggybacks on a rash of announcements in the space, most notably the robo service being offered up by Josh Brown and Barry Ritholtz I wrote about a few weeks ago, and the recent announcement from Fidelity that it would white-label Betterment’s robo service.

We also have tons of action on the venture capital front this week. Wealthfront has raised $64 million in VC money, and Personal Capital just closed a $50 million round with investors that include USAA—a natural target customer for these kinds of services.

The Problem Being Solved

On the one hand, this is a fantastic development. According to a note published today by the Employee Benefit Research Institute, the average investor (and sorry, there’s no other way to put this) is insane. Here’s the money quote from its study of asset allocation changes among IRA investors from 2010 to 2012:

“This study includes the first look at asset allocation longitudinally from 2010‒2012 and finds that equity allocations in 2010 were very similar to those of 2012. This result appears to be driven by the almost-60 percent of accounts that remained at an extreme value (0 percent or 100 percent allocation) in both years.”

Think about that for a moment. More than half of all IRA investors—over the two-year period, not just, say, in January 2010—were either 100 percent in equity, or 100 percent NOT in equity.

Clearly, any virtually well-constructed ETF portfolio makes more sense than this. So if Schwab’s new “Intelligent Portfolios” could replace these allocations with a nice balanced-looking pie chart of super-cheap ETFs, that’d be swell.

But Solutions Don’t Always Work

The problem is, I don’t think it will. This latest round of super-simplified portfolio management services is trying to solve a problem that has existed essentially forever, particularly with investors saving for retirement.

One of my earliest gigs was managing the 401(k) sales force for what was then Wells Fargo Nikko Investment Advisors, the firm that would become Barclays Global Investors and then BlackRock, and which most folks know as the progenitor of iShares ETFs. Back then, in the early 1990s, we were trying to solve two big problems:

  • Give institutions better index building blocks. The solution there was the WEBS product line, which became iShares.
  • Convince people to be smarter about their retirement investing. The solution there was called LifePath, the very first target-date funds.

Target-date funds remain a fantastic idea for a certain profile of investor: someone who doesn’t want to think about their portfolio, and doesn’t have a lot of personal opinions about things like macroeconomics. While they’ve never caught on in ETFs (for obvious reasons—ETFs in 401(k)s are still extremely rare), they’ve gathered on the order of $670 billion in assets in the past 20 years.

At their core, they’re an answer to the question, “What should I be invested in?” And all you need to tell the fund manager is when you need the money.

 

Rocket Science?

But here’s the dirty little secret: Constructing a portfolio is not rocket science.

I can teach my kids how to run a mean-variance optimizer plug-in in Excel and how to select a blend of assets on the resulting efficient frontier.

And that’s what, I predict, you’ll see from all the various new platforms that are launching; somewhere between three and five simple portfolios of various tranches of stocks and bonds. They’ll all look vaguely similar to the portfolios Elisabeth Kashner analyzed in her robo-advisor breakdown this fall. They’ll be on a spectrum of conservative to aggressive, and they’ll all look … well … fine.

And indeed, if they do in fact lure investors out of their 100 percent or 0 percent equity portfolio, those investors will probably be better off. Even better if they lure them out of expensive actively managed mutual funds.

So what’s not to love? It’s actually too simple. When things get too simple, people stop paying attention. If something is simple, it often feels like it can’t be that important.

My concern is that we’re heading for a world where every place investors interact, there’s a set of “robo portfolios” sitting in front of them, and investors will be lulled into a sense of “Well, I’m average; I’ll take the average portfolio” and they’ll never think about it again.

They won’t remember to adjust their position as they get closer to retirement. They won’t realize the implications of an early withdrawal. They won’t understand that investing in the stock market while you’ve got credit-card debt piling up is a dumb idea.

Worse still, they won’t think they need a financial advisor, because it’s all being taken care of by computers. It’s understandable. After all, haven’t we all been talking about “investing as a science” for years?

Maybe it is. But people? People are messy.

 


 

You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.


 

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