Rebooting Robo Advisors’ ETF Selection

Rebooting Robo Advisors’ ETF Selection

A robotic focus on expense ratios costs more than you think.

Director of Research
Reviewed by: Elisabeth Kashner
Edited by: Elisabeth Kashner

A robotic focus on expense ratios costs more than you think.


This is the fourth blog in a multiple-blog series by’s Director of Research Elisabeth Kashner on the new “robo advisory” industry. The first was titled "Which Robo Advisor For My Teen?”;  the second was titled "Ghosts In The Robo Advisor Machine”; and the third was titled "Inside Robo Advisor Asset Allocation”.

Thirteen years ago, my husband and I half expected to find a tiny maple leaf on our newborn’s bottom, because our California baby had been—ahem—made in Canada. Our family has a soft spot for our neighbors to the north.

How sad that only one of the six all-ETF robo advisors—the firms we’re considering as managers of his bar mitzvah money—offers even a sliver of exposure to Canadian equities.

Canada boasts the fifth-largest stock market in the world, larger than France’s or Germany’s. The iShares MSCI Canada ETF (EWC | A-92) returned 10.9 percent per year in the decade ending July 30, 2014, versus 8.7 percent for the U.S.’ Russell 1000 Index.

Have the robots gone rogue? Why did they boot out Canada?

Not deliberately. Canada, it turns out, is a casualty of the robo advisors’ ETF selection process, which prioritizes low expense ratios over all other criteria.

Beyond The Price Tag

The chief investment officers (CIOs) of these robo advisors aren’t measuring the true costs of ownership, or the opportunity cost of portfolio gaps. As a result, they’re missing real opportunities.

Wealthfront and Betterment could offer state-specific muni funds. The iShares California AMT-Free Muni ETF (CMF | B-85) and the iShares New York AMT-Free Muni ETF (NYF | B-88) are efficient and accessible, trading a median $1,300,000 and $700,000 per day, respectively. The long-term tax savings are probably worth the extra 0.11 percent trading spread cost between these two funds and the iShares National AMT-Free Muni Bond ETF (MUB | B-74).

Betterment and Future Advisor could get a stronger small-cap/value tilt with Guggenheim’s S&P 500 Pure Value ETF (RPV | A-64). With the fund’s 1.39 price-to-book ratio (P/B) and its $37.3 billion weighted average market cap, the value tilt both firms get by allocating to the Vanguard Value ETF’s (VTV | A-96) is lower. VTV clocks in with a 2.04 P/B and $127 billion weighted average market cap.

FutureAdvisor and Covestor could tailor their U.S. aggregate bond exposure. FutureAdvisor needs liquidity to support its tax-loss harvesting program, and so should hold the iShares Core U.S. Aggregate Bond ETF (AGG | A-97) that Covestor favors (AGG has 0.02 percent spreads, versus 0.07 percent for the Schwab U.S. Aggregate Bond ETF (SCHZ | A-99). At the same time, Covestor should focus on SCHZ’s long-term holding costs (-0.10 percent median annual tracking difference, versus -0.13 percent for AGG). Instead, both firms have done the exact opposite.

Invessence could avoid a 500-stock hole in its U.S. market coverage by switching from the SPDR S&P 500 ETF (SPY | A-98) to the iShares Russell 1000 ETF (IWB |A-92).


Global-Equity Selection

But it’s the 35 to 83 percent of the equity portfolios—the core global equity suite—that has the most room for improvement.

Wealthfront, Betterment, Future Advisor, Covestor and WiseBanyan could get complete coverage of the non-U.S. equity market by using the Vanguard Total International Stock ETF (VXUS | A-99). VXUS covers Canada and small-caps, while the Vanguard FTSE Developed Markets ETF (VEA | A-91) and the Vanguard FTSE Emerging Markets ETF (VWO | C-90) that the firms favor have neither.

Second best would be the iShares Core MSCI EAFE ETF (IEFA | A-93) and the iShares Core MSCI Emerging Markets ETF (IEMG | B-99), which would include small-caps, though not Canada.

At, we admit we’re not experts in portfolio construction, but we stake our reputation on understanding ETF due diligence. That’s why we make sure to rank every ETF for operational efficiency, trading costs, and the breadth and representativeness of its portfolio, examining multiple aspects of each.

ETF Due Diligence

Let’s take a look at the robo advisors’ core global equity suite, going step by step through the fund selection process, so we can see where the wheels came off. It’s going to take me two blogs to show you why.

In today’s blog, I’ll lay out a logical ETF selection process, assessing the robo advisors’ needs, understanding the available choices, and ranking the top selection criteria. Next time, I’ll apply those criteria as I choose a pair of developed ex-U.S. and emerging market ETFs.

Are Three Funds Better Than One?

The Vanguard Total World Stock ETF (VT | B-100) includes Canada, small-caps—99 percent of the global equity market in all. So why don’t the robo advisors just allocate to VT? What do they need in a core global equity allocation? I asked them; they told me.

All of them want what calls “plain vanilla” funds—broad-based, market-cap-weighted funds that aim to replicate a market segment. But that’s not all.

One courageous robo professional admitted that clients prefer some complexity, finding more value in a three-fund suite compared with just one.

Sanjoy Ghosh, CIO at Covestor, wants flexibility for tactical shifts, because Covestor is currently researching a tactical rotation model.

Jon Stein, Betterment’s CIO, wants to create opportunities for rebalancing and tax-loss harvesting, citing a “trade-off between the elegance of the portfolio and the ability to tax-loss harvest effectively.”

Wealthfront’s CIO, Burt Malkiel, values the ability to over- and underweight subasset-classes like emerging markets based on expectations of higher risk-adjusted returns. He also explained that Wealthfront corrects for some of the heavy float adjustments that depress the weights of firms like China’s state-owned enterprises.

Marketing, tax-loss harvesting, and flexibility in asset allocations forced the robo CIOs away from VT, and into a modular three-fund suite.


When Eight Plus 10 Makes Six

There are eight plain-vanilla U.S. total markets choices, and five vanilla sets of developed ex-U.S. and emerging market pairs to choose from—18 funds, in all. Presumably the robo CIOs want to choose the best in each segment, without regard for branding. Too bad that indexers—and ETF issuers—make mixing and matching nearly impossible.

Actually, it’s not that terrible until you get to the international funds. The U.S. is simple, because you can choose a U.S. total market fund independently of the other two.

Among the U.S. funds, the Vanguard Total Stock Market ETF (VTI | A-100) offers the broadest, most efficient coverage of the U.S. markets, with excellent liquidity. That’s why VTI wins’s Analyst Pick award in the Equity: US Total Market segment. Every robo advisor except Invessence chose VTI.

Now we’re down to 10 funds—but not really. You can’t mix and match developed ex-U.S. and emerging market ETFs because of South Korea. S&P and FTSE indexes include South Korea among developed nations; but MSCI groups it with the emerging economies. Index-tracking funds follow suit. SPDRs, Schwab and Vanguard put South Korea in their developed-markets funds; iShares keeps it in emerging markets.

If you combined IEFA and VWO, you would have a gap; namely, no South Korea. But if you held VEA and IEMG, you’d double up on Samsung.

So you have to choose these funds in pairs, to get full international coverage. Robo CIOs either have to stick with iShares, or use some combination of Schwab, SPDR and Vanguard funds. Let’s keep this in mind as we walk through the fund-selection process.

Which Costs Matter Most?

Whether choosing single funds or pairs, investors—robo CIOs and all the rest of us—had best consider three types of costs when choosing ETFs: opportunity cost; holding cost; and trading cost. Of the three, opportunity cost is usually the largest.

Opportunity cost reflects the cost of missing out of the global opportunity set. It’s the future returns of the stocks or bonds you don’t hold.’s ETF Analytics reflects opportunity costs in our fund reports; you’ll find it in the “Fit” tab.

Holding costs include obvious factors such as the expense ratio, but also include tracking error as well as securities-lending revenue—as in the securities-lending income, not cost—among others. Look in the “Efficiency” tab of our fund reports for more details.

Trading costs are best represented by spreads, but can include market impact, slippage, and premiums and discounts. You’ll find plenty of information on trading costs in the Tradability tabs of our fund reports.

For the developed ex-U.S. and emerging market funds, the historical average costs stack up like this:

Opportunity: 0.28 percent

Holding: 0.20 percent

Spreads: 0.07 percent

A logical fund-selection process would focus first on minimizing opportunity costs, and second on holding costs. Frequent traders, including those who offer tax-loss harvesting services, will have to balance trading costs with holding costs, weighing the combination against opportunity costs.

That’s what I’ll do in my next blog. Meanwhile, if robo returns head south, don’t blame Canada.

At the time this article was written, the author held no positions in the securities mentioned. Contact Elisabeth Kashner, CFA, at [email protected].


Elisabeth Kashner is FactSet's director of ETF research. She is responsible for the methodology powering FactSet's Analytics system, providing leadership in data quality, investment analysis and ETF classification. Kashner also serves as co-head of the San Francisco chapter of Women in ETFs.