Why Robo-Advisors Endorse Exchange Traded Funds

Wall Street has experienced a revolution in the investment industry. Services such as Wealthfront, Betterment and Vanguard’s Personal Advisor in the U.S. have shifted to providing investment advice online. These so-called robo-advisors assess an investor’s appetite for risk and match it with a diversified portfolio of exchange traded funds (ETFs), and a large part of the portfolio management is handled by algorithms.

The increasing popularity of robo-advisors leads A.T. Kearney to expect assets under management of these firms to reach $2 trillion by the end of 2020 in the U.S. This figure represents a market share of 5.6 percent, up from just 0.5 percent today. It is also likely that consumers will experience a rapid evolution of these platforms as technology will continue to push the intelligence of automated advice and algorithms to the next level.

The robo-advisory landscape in Europe is still in its infancy compared with the market in the U.S.

Nutmeg and Swanest in the UK, vaamo in Germany, TrueWealth in Switzerland, MoneyFarm in Italy and Marie Quantier in France are setting the stage. The winner is the consumer, profiting from decreasing prices, greater access to investment advice, smarter services and a lot more transparency.

Common among all these ventures is their endorsement of ETFs, which they use to build diversified investment portfolios.

The Robo-Advisors’ Preferred Choice

ETFs are a smart investment choice, but not only because of their low-cost approach to market exposure. Their beauty also lies in their simplicity and transparency. Active fund managers often struggle to define exactly where their client’s money is invested, as positions in a fund can change on a daily basis. Even worse are fund of funds, blurring the holdings even more.

As ETFs track a benchmark index, it becomes very easy for an investor to identify his/her holdings. If someone acquires an ETF that tracks the FTSE 100 index, the investor will simply be holding the 100 largest companies in the UK.

ETFs not only enable investors to access mainstream markets like the FTSE 100 and the Nikkei 225, they also offer an entire universe of possibilities: access to single countries, industries and commodities are made possible through the bundling of stocks, bonds and futures in the form of ETFs.

Furthermore, ETFs are traded on the stock exchange: anyone with an online brokerage account can enjoy access.

Education Is Still Needed: Robo-Advisers Can Help

As more and more evidence supports the benefits of ETFs, an increasing amount of investors are moving their assets into these vehicles. A study from Vanguard shows that 30 percent of mutual funds’ assets in the U.S. are managed passively, compared to 12 percent in Europe. In addition, the industry grew 27 percent in the U.S. and 35 percent in Europe on an annual basis over the last 10 years. However, the major part of these assets are coming from institutional players and not from retail investors.

The reason the average investor is not aware about ETFs is simple. Traditional financial institutions cannot make profit from ETFs. Banks offer free investment advice, but make money with the management of their own funds that they promote and administer. In the past, investment advisers often received kick-backs, a form of remuneration paid by providers of actively managed funds to advisers for the promotion of their products, effectively eliminating advisers’ incentive to inform clients about ETFs. However, with the implementation of MiFID such practices are no longer allowed. As a consequence, investment advisers have to reinvent their fee structure.

Robo-advisors do not take commission from third parties: they earn revenue through the provision of asset allocation, return optimisation and tax-loss harvesting. They tend to be much cheaper than traditional fund management services and thereby democratise the wealth management industry.

However, it is worth mentioning that the world needs traders who set prices in the markets. If everyone just followed the stock market, say, via an ETF, the system as it is designed today would not work.

All Plain Vanilla?

ETFs offer a tremendous number of benefits, compared with traditional investment products. But at Swanest, not all ETFs are equal and we have to be astute when we select a product.

ETF providers have become creative and started offering leveraged products, possibilities to shorten positions and apply alternative indexing methods. Investors do therefore need to be careful not to take a risk they do not fully understand. Don’t forget that certain ETFs might not be highly liquid in the market and therefore may cause bid-offer spreads that can negatively impact investment performance.

Despite these considerations, ETFs remain highly attractive. They offer a very smart investment strategy at a low cost, are extremely transparent and provide access to a universe of opportunities. Robo-advisors will help investors with the small hurdles they face when investing in an ETF and provide support along the way to make sure their clients reach their financial goals.

Silvan Schumacher is co-founder and CEO of Swanest, a UK-based robo-adviser.