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.
Here’s who should seriously consider using a robo-advisor, how they should be used, and what to look out for…
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.
Today, I’m tackling what the real problems are with robo-advisory services – who should use them, and how not to get crushed when they go haywire.
Depending on what theories and math robo-advisors are wired for, they construct a “personalized” portfolio based on forms you fill out online, and they automatically rebalance your portfolio when threshold weightings of positions in your portfolio get out of balance.
And that’s precisely where the issues begin…
Ghosts in the Machine
The first problem with these services starts there, in their construction of portfolios.
They are personalized- but only to the degree that you fit into a model that fits thousands or hundreds of thousands of other hopeful investors. So, don’t count on your portfolio being different to the point where you believe it’s immune from what anyone (or everyone) else might suffer through if markets blow up.
Generally, you’re put into “passive” low-cost indexed ETFs. Investors plowing in larger sums at some services, like Wealthfront, can have a combination of individual securities and one or two “completion ETFs” to track an index.
If you’re investing 100% in U.S. equities and expect robots to diversify you, they will… but they won’t.
The bottom line is, no matter how robots break up your funds- whether they put you in several big index ETFs tracking the likes of the S&P 500, the Dow Jones Industrials, or the Nasdaq- you’re essentially correlated to the market.
Robots can put you into large-cap ETFs, small-cap ETFs, growth ETFs, value-oriented ETFs, into ETFs indexed to divided sectors or industries, or smaller subsets of equities based on fundamentals, dividends, almost any subset of stocks based on almost any theme. There are lots of indexed “products.”
But you’re still correlated to the market.
It may matter what indexes you’re in on the upside, in the short run. It won’t really matter in the long run if you’re well diversified across all these indexes and groups. You’re being indexed enough, diversified enough, to essentially just follow the general market.
On the downside it matters, because correlation is what it is: a phenomenon, whereby most equities breakdown when faced with widespread selling by individuals, hedge funds, and mutual funds. It matters especially in the short-run, regardless of how “uncorrelated” to each other these equities are supposed to be.
Then there are the ETFs. That’s what you’re mostly invested in with robo-advisory services.
If you don’t remember what happened to ETFs last August, you need to be reminded here and never forget.
Because ETFs are composed of actual stocks, or futures, other assets, or derivatives for that matter, they are priced based on the sum of their parts. Last August, before markets opened, futures prices were down sharply. Everyone knew stocks would likely selloff hard at the open. And… they did.
The problem with ETFs suddenly surfaced. How can you open trading in a security if the price of that security (an ETF), is based on other stocks that aren’t open, or opening, and have no prices? You can’t really. If you do, you’re just guessing.
So while lots of ETFs weren’t opened for trading, the constituent stocks that they’re made of were going down.
What happens to your portfolio if your robots can’t sell your ETFs while the stocks that make them up are going down?
You could be devastated.
The Faults in Correlation
Now, we’re back to correlation. If stocks are going down and some investors can’t sell what they want to sell, they’ll sell whatever they have to, including other asset classes.
That’s cross-asset correlation. Everything gets sold and sometimes there are no safe harbors. Usually when there’s panic selling, the Treasury bond market becomes a safe harbor and prices of bonds rise.
Maybe your robot will have you in a small T-bond position. You’ll at least have that.
Robo-advisor advocates would argue it would be unlikely an investor would be 100% in just U.S. equities based on their models. But their models are based on investor inputs. And if an investor wants all equities, and all-American equities, they’ll get that.
As far as cross-asset diversification, especially achieved by mean-variance analysis (a favorite of most robo-advisors), Mark Broadie, Professor of Business at Columbia University, has demonstrated through simulations that “the error maximization property of mean-variance analysis becomes more pronounced as the number of asset classes increases.”
In other words, you’re more prone to larger standard deviation moves on both the upside and downside the more diversified you are in different asset classes.
And, you know now that matters more on the downside, because that’s when the big moves – the “fat tails” wreck all normal distribution-based models… which all of the robo-advisors are based on.
You don’t have to worry about much on the upside. Your robo-service will make you money, but being as indexed as you’ll be, don’t expect to outperform the market.
On the downside… good luck. You’ll get creamed along with everyone else when markets tank, maybe worse if the ETF market implodes from structural issues.
That’s in the short-term. If you’re a long-term investor you’ll be told to sit back and let the markets come back and lift you up when the correction or panic passes.
While this is historically true, what if you need to take money out in the short-term? What if you don’t have a long investing horizon? What if you were just trying to maximize your investment portfolio before moving more into bonds?
Portfolio construction is a problem, diversification is a problem, ETFs are a problem, correlation is a problem, the normal distribution math used is a problem – there are lots of problems with robo-advisory services.
If you’re an investing beginner and having a portfolio automatically constructed and rebalanced for you gets you into the market, I’m all for it. Go with it.
But, understand the pitfalls in blindly expecting a robot to understand you, the markets, and protect you from serious harm in the short-term, or the long-term. I only advise you use a robo-advisor if you manage that account and plan your contingent moves into the future and be ready to execute them when you have to.
There are so many things we can learn about investing from automated investment services, otherwise known as robo-advisors, that it staggers the mind.
After all, they’re computer-driven platforms imbued with advanced Sharpe, mean variance, and Modern Portfolio Theory that produce “efficient frontier” portfolios, and whose proprietary algorithms rebalance your portfolio based on threshold continuums and your personal dreams and goals.
Oh yeah, they’re complicated.
But there’s one lesson (one you were never taught) you can learn from taking a good, long look at how these robo-advisory services construct and rebalance your personal portfolio.
Because as we’re driven toward a future programmed by algorithms and dominated by Fintech innovations, it’s important to stop and take stock of some of the basic assumptions that will inform that future.
As you’ll see, there’s one fundamental assumption – upon which millions of portfolios have been built – that’s simply dead wrong.
Automated investment services – more commonly known as robo-advisory accounts – are relatively simple to understand, on the surface at least.
We talked about this last week – robo-advisories were created by millennials in response to the dot-com collapse, the financial crisis, and traditional fee-based advisory services.
But all is not what it seems. And if you dare dig into how they actually work, you’d be surprised how complex they are.
Today, I want to show you how these services actually automate portfolio selection and perform rebalancing acts, and help you understand some of the complex portfolio management theories providers have to use.
Because what you don’t know can really hurt you – and you should know how your money is being managed.
I’ve been telling you for most of 2016 that financial technology, or Fintech, is changing the investing and trading landscape.
One of the most profound Fintech disruptors is the creation of automated investment services, more commonly known as “robo-advisors.”
The idea of automating investment services was the brainchild of a handful of millennial-focused Fintech entrepreneurs, most of whom are millennials themselves.
With their general aversion to traditional fee-based advisory services, their experience of living through the tech-wreck of 2000 and the 2008 market shellacking, their comfort and trust in computers and technology, millennials (the generation born or coming of age between 1982 and 2000) were presumed to be the perfect audience for robo-advisory services.
Sure enough, assets under management by robots (and their human helpers) exploded into the billions this year.
But millennials aren’t the only group who are enamored with these low cost, automated investment services. They’re catching on with lots of investors.
If you’re not one of those investors, today, I’m going show you how robo-advisors work and what they cost, as well as the pitfalls associated with this newfangled investing horizon.
The stock market was supposed to have a major beef with Donald Trump’s election.
Now that Mr. Trump is the president-elect, everyone’s asking “Where’s the beef?”
That famous quip comes from a 1984 Wendy’s commercial assailing claims that Big Macs and Whoppers had meatier patties. That same year, Walter Mondale used it to mock Gary Hart’s proposed agenda, and later used it against Ronald Reagan, who eventually won a second term.
The answer today, as far as stocks are concerned, is there looks to be a lot of red meat in the economic future president-elect Trump’s proposing.
And as U.S. investors start to get it, they’re rotating into select stocks instead of shedding positions as everyone expected.
It’s too early to tell what investors are or aren’t going to fully embrace, since we don’t know who president-elect Trump will surround himself with and what exactly his agenda will be.
But that doesn’t mean investors should stand by with their wait-and-see glasses on.
There’s one opportunity in our future that’s a no-brainer – because it’s the central pillar of Donald Trump’s economic plan.
We’re nearing the end of what has been the longest presidential campaign in history. And no matter which candidate you’re voting for, the opposition looks like a dangerous choice.
The truth is, as far as the market is concerned, Hillary Clinton and Donald Trump are both dangerous, for different reasons.
Fortunately, no matter who you’re supporting, whether you’re a republican, or a democrat, or something in between, there are a few smart bets you can make now – and rake in good profits on the election outcome.
Here are the real dangers we’re facing this election…
Don’t Make Any Long-Term Moves
First of all, right now, the smart bets are all short-term moves.
That’s because there’s no way of knowing who’s going to win the election and which long-term bets are going to pay off, since both candidates have completely different political and economic agendas.
That said, the only long-term play to make right now is to do nothing… if you’re sitting on a diversified portfolio of great companies (not great stocks, mind you, but great companies).
In the long term, whomever wins the election – meaning which party runs the executive branch of government – doesn’t make much difference to the stock market.
According to Russ Koesterich, CFA and head of BlackRock’s global asset allocation team, “Historically, whether a Republican or Democrat occupies the White House has had no statistically significant impact on US equity markets.”
And research going back to 1853 shows that returns under Republican and Democrat administrations are virtually identical. That’s according to Dr. Jonathan Lemco of mutual fund giant Vanguard.
In the long term, which for me is five years out, stocks have nowhere to go but up.
If either candidate wins by a landslide, which is unlikely, there would be smart long-term plays to make, for sure. But we’ll cross that bridge if we come to it.
In the short-term, however, until the dust settles sometime after this election, staying on the sidelines with big money makes sense.
It also makes sense to put on smart short-term positions to profit from likely outcome turmoil.
My position on the outcome is that no matter who wins, unless it’s a landslide, the vote is going to be contested, lawsuits are likely to fly, we could face a constitutional crisis, and there could be civil unrest.
I’m not the only one who thinks there’s trouble ahead.
University of Michigan economist Justin Wolfers co-authored a study that warned a victory for Donald Trump could result in US, British, and Asian markets plummeting by 10% to 15%.
According to the report, which is based mostly on how markets acted during the first presidential debate on September 26, besides equities selling off, a Trump victory could cause oil to fall $4, and trigger a 25% decline in the Mexican peso.
Wolfers’ says that the “Trump discount” is comparable to those that accompanied the Brexit vote or the 2003 invasion of Iraq, and could “significantly increase expected future stock market volatility.”
And a 2012 Goldman Sachs report titled, “3 Reasons Why Investors Should Take US Election Cycles Very Seriously” says:
The political stakes in presidential, parliamentary, or legislative elections often translate into changes in policies that can reshape the economic environment. Second, the regularity with which elections take place in most countries may give place to cyclical patterns in government and investment behavior. And third, elections can markedly increase political and social uncertainty. These three factors have the potential to affect all asset classes, especially equities, given their strong sensitivity to changes in the economic outlook.
One Thing’s For Certain on November 8
America’s never had two more polarizing candidates. They not only seemingly hate each other, but rally their supporters into fighting corners and demand they come out swinging.
The one almost given in this election is that volatility is going to rule the markets, across all asset classes.
In my Capital Wave Forecast and Short-Side Fortunes trading services, we’re already long volatility, betting that the VIX is going to make new 52-week highs.
We’ve also got straddles on the U.S. market, which means we’ve taken a split position, at very cheap prices, that there will either be a huge relief rally if Clinton wins or a major selloff if Trump wins (or if the market goes down just because investors want to take profits in the face of what may be a very uncertain future).
We’re going to add to our downside bets and volatility bets as the odds of a Trump victory increase, which they have been doing lately.
Buying calls on the VIX, or buying call options on the more leveraged iPath S&P 500 VIX Short-Term Futures ETN (NYSEArca:VXX), makes sense if you’re expecting the kind of volatility that accompanies panicky markets – and we are.
And buying straddles – which make money if the market goes radically higher or lower, it doesn’t matter as long as there are big moves – makes sense too.
We own calls on a market-following ETF and calls on an inverse market ETF.
“Our financial markets have become a Vegas/Macau/Monte Carlo casino,” bond guru Bill Gross wrote in the October edition of his widely read monthly newsletter.
And the way to bet this election in the big casinos is by putting down short-term bets on volatility, on big moves either way, and on other positions that’ll tell you about on Friday.