Automated investment services, or robo-advisors, are taking over the world.
Well, not quite.
But they are getting lots of attention and attracting billions of dollars.
While I’m a huge fan of the concept of automated investing services and I believe they will get a lot better, they’re far from “there.” And they’re not for everyone.
You’ll need to keep your eyes open so you don’t get sideswiped by internal conflicts some service providers present, and don’t end up down a rabbit hole you didn’t see on the horizon.
Who They Could Help, Who They Could Hurt
Anybody who wants be invested in the market but doesn’t know how to start should consider opening up an account with a robo-advisor.
Anybody who is a DIY investor, who hasn’t been successful doing it yourself, and doesn’t want to pay for a full service broker should also consider opening up a robo-advisor account.
Anybody who isn’t happy with the performance of their stockbroker or wealth manager – especially in terms of how much fees and commission are eating into their returns – should consider opening up a robo-advisor account.
Robo-advisory services make investing in the markets, building a diversified portfolio, and automatically rebalancing it incredibly simple.
And simple is great if it gets individual investors off the sidelines and into the game. Or if you haven’t been successful doing what you’ve been doing and want non-biased (for the most part) advice on establishing an investment portfolio, automated services are a simple answer.
Unfortunately, under the hood, robo-advisory portfolio construction and rebalancing principles, pricing theories, and the math inherent in convening all the moving parts that make investing in general more of an art than a science, is anything but simple.
I’ve written a lot about what’s under the hood of these services, but you don’t have to understand everything about what’s under the hood (the complex math, for example). You just have to know what to do when the investment car that’s being auto-driven for you looks like its heading for a brick wall.
A False Sense of Security
First of all, would you get into a driverless car today and just fall asleep, or read, or talk on your smartphone as if the technology had been perfected? Of course you wouldn’t.
Just because your investment portfolio has been automatically created for you doesn’t mean you shouldn’t know exactly what’s in there and where the ride’s taking you.
Automated doesn’t mean blind. You should always know what’s in your portfolio and how each of the positions are doing, whether they’re making money or losing money and what your account balance is doing relative to the market.
The problem with robo-advisory services, and it’s a giant problem, is that a lot of investors aren’t going to pay attention to what’s in their portfolios and how they’re doing.
That’s no different than investors buying mutual funds and expecting that’s mutual fund managers will just make them money with their picks and rebalancing strategies.
Don’t go in blind just because you think technology is somehow foolproof. It’s not.
The good news is that 99% of the time robo-advisors will have you in ETFs. They use ETFs because there are so many of them that allow investors to invest in different indexes, different markets, different industry groups and sub-groups and different asset classes, that being diversified has never been easier.
The bad news is, as I’ve warned you about, when there’s a market crash it almost doesn’t matter what you’re invested in, because indexes and markets and different asset class become highly correlated, they all usually go down.
If you’re in an auto-driven car and you see it heading for a wall, hopefully you’d be able to do something about it, like yank the wheel or hit the brakes.
You can yank the wheel of your robo investment portfolio by changing your investment parameters online, and you can hit the brakes by selling your portfolio.
The point is, ETFs aren’t the be-all-end-all of diversification, partly because of structural problems inherent in all ETFs, which I wrote about here (and you definitely need to read).
But if you know what’s in your portfolio and see a crash coming, you can sell some of your ETFs or easily buy put options on them to hedge your entire portfolio.
While that might get a little expensive, it wouldn’t be at all if it saved your account from getting crushed in the next crash.
Of course, you don’t have to do any hedging or sell any positions if you have a long-term holding timeframe for your investment portfolio. You can always hope that over time the markets will heal themselves and get back on bull track.
Pitfalls, Conflicts, and Legal Issues
Robo-advisory services are no different than any other investment track you can run on. There are always going to be corrections and crashes and you’re always going to be exposed to losses. It’s just a matter of how comfortable you are sticking with the investment program you’re following, or how you proactively defend your investment capital if you see trouble ahead.
Speaking of trouble… robo-advisory services aren’t always conflict-free. Their status (acting in the capacity of a Registered Investment Advisor) doesn’t mean you have the same rights you might think you have if you were exposed to inordinate losses due to the fault of a human advisor.
As far as conflicts, they’re out there.
For example, some service providers receive compensation for offering third-party ETFs on their platforms. Some providers may be market-makers and traders in the underlying stocks held by ETFs. And service providers can be “authorized participants” who actually create and redeem the ETFs their services put you into. That gives them a lot of power over pricing and also a huge head start in selling underlying securities that make up an ETF if they know there’s going to be a lot of investor liquidation of ETFs.
Selling the underlying securities that make up an ETF portfolio can put more pressure on the ETF price and cause a negative feedback loop. That can happen on a massive scale with ETFs, which is a structural problem inherent in the ETF universe.
If something goes terribly wrong with your robo-advisory account, don’t think that just because the service provider had to have an RIA set up through which it offers automated investment services that you’re protected by the laws that govern RIAs.
Most services tell you that your robo-advisor is and will act as an independent contractor, that it is not an employee of the client and has no other relationship with the client. The service is just a service, and the robo-advisor can’t be said to be acting in the best interest of the client because the client is supposedly acting in his or her own best interest by setting the parameters when they open their account.
Don’t get me wrong, I like robo-advisory services if they gets folks involved in investing.
They’re just not all there yet, and may never be. That’s why you still have to know what’s in your portfolio and how it’s doing, and more importantly, take responsibility and action when it comes to your money.
Stay tuned. In the coming months, I’m going to show you how we can improve upon robo-advisory strategies and techniques… and even how we can use them to profit.