Online investment services, more commonly known as “robo-advisers,” are among the newest offerings from the professional financial world to the individual investor. Robo-advisers advertise themselves as an inexpensive and effective alternative to traditional financial advisers. In our ongoing coverage of robo services, Computerized Investing is taking a closer look at the implications of their claims on the individual investor. It is important for anyone considering entrusting their savings to an automated service without having a face-to-face meeting with an adviser to understand the possible pitfalls.

The Problem of Definition

Robo-advisers provide an automated service that offers diversification, rebalancing and asset allocation based on each investor’s risk/return profile. While the term robo-adviser connotes a particular relationship between the analytical decisions and financial management of a portfolio, the term is loosely applied to a wide range of online investment services. Many of the services offered by robo-advisers only represent a small piece of the puzzle of investment management because they don’t analyze a client’s wealth as a whole. Additionally, they tend to “bucket” investors based on risk/reward assumptions as opposed to creating a customized risk/reward profile as certified financial planners (CFP) and chartered financial analysts (CFA) are required to do.

However, there are some robo services that are more comprehensive and do in fact analyze an investor’s entire portfolio and wealth.

As Computerized Investing began researching robo services and what they offer, we discovered how opaque the world of the robo-adviser is and how unique each approach is in the application of an automatic decision-maker. This general lack of consensus as to what a robo-adviser is and isn’t has largely contributes to the confusion of determining the true performance of many of these automatic portfolio managers.

When reading through the attributes of the decision-making process that robo-advisers use, much comes from the concepts of modern portfolio theory (MPT). Mentions of MPT are quite ubiquitous in firms’ descriptions of their process for generating a proper asset allocation based on pre-determined risk/reward categorizations. The risk/reward categorization is probably the first thing an individual investor notices when entering a robo-adviser’s webpage for the first time. Investing in a portfolio or fund managed by a robo-adviser usually requires the investor to give generic information that lumps them into a certain risk/reward group, and, subsequently, a matching asset allocation.

Critics are quick to point out that this oversimplifies an investor’s needs and thus their investment options. The Department of Labor (DOL) has called robo-advisers a benefit to retirement investors due to their minimization of costs and unbiased management. However, the Securities and Exchange Commission (SEC) has remained cautious and regards robo-advisers as potentially just as biased as their operators due to incomplete information, incorrect assumptions and other non-investor circumstances that surround their operations. It’s worth noting that robo-advisers are required to register as investment advisers under the Investment Advisers Act of 1940 or applicable state law.

On May 8, 2015, the SEC and the Financial Industry Regulatory Authority (FINRA) issued a warning to investors regarding robo-advisers and their services. The warning is summarized in the following points:

1. Understand any terms and conditions.
2. Consider the tool’s limitations, including any key assumptions.
3. Recognize that the automated tool’s output directly depends on what information it seeks from you and what information you provide.
4. Be aware that an automated tool’s output may not be right for your financial needs or goals. 
5. Safeguard your personal information.

To see the full warning, click here.

Research Outlines Robo Weaknesses

Melanie L. Fein, attorney and former faculty member of Yale Law School, published a legal essay in 2015 called, “Robo-Advisors: A Closer Look.” She takes robo-advisers to task for what they represent as their abilities to garner return for investors and the claimed advantages they use to attract investors with. In her research, commissioned by financial management firm Federated Investors, Fein concluded that robo-advisers “do not provide investment advice that is necessarily in the customer’s best interest, are not free from conflicts of interest and do not necessarily minimize costs.” In her paper and based on her research, Fein observed that many robo-advisers:

• Do not provide personal investment advice,
• Are not free from conflicts of interest,
• Do not necessarily minimize costs,
• Do not act in the best interest of the client,
• Do not meet the standard of care for fiduciary investments, and
• Are not designed for ERISA retirement accounts and would not meet the DOL’s proposed “best interest” contract exemption.

Below is a highlight of some of the main points made in Fein’s paper. Note that the views described in Fein’s work are not that of AAII. Most of the observations made are applicable to robo-advisers that are more passive in nature. There are robo-advisers that overcome some of the pitfalls outlined here; this article is meant to highlight some of the commonly noted arguments against using a robo-adviser.

Lack of Personal Investment Advice

Perhaps the most touted advantage of robo-advisers is the hands-off approach and worry-free confidence they provide investors. In order to ease prospective clients’ concerns, many robo services ask a series of questions (usually no more than 10) in order to generate a risk/return profile. In reality, arriving at a personalized investment strategy by a hands-off approach based on answers to a brief questionnaire and no personal interaction with a financial adviser should seem paradoxical.

Fein found that in some cases the robo-adviser requires applicants to sign an agreement stating that “the robo-adviser will manage the client’s account ‘in accordance with the Plan.’” The “Plan” is the course of action the robo-adviser determines for the client at their surveyed risk/reward threshold. Any desire the investor may have to avoid certain securities or allocations is not taken into account. For example, if the client doesn’t want to hold stocks in emerging markets, there is typically no way to assert this to a robo-adviser; the service will automatically do as it sees fit based on its risk/reward algorithm.

Many investors don’t want to be involved in asset allocation specifics and prefer not to think about where and why to invest. On the other hand, the educated individual investor might be less interested in robo-advisers that claim to offer personalized service without the investor’s detailed input. Many services ask the investor to select their level of risk aversion from an arbitrary scale. For some, this will be appealing in its simplicity, but precautions should be taken to understand what vehicles a robo-adviser will deem worthy of investment.

Many robo-advisers start with a question about the investor’s goal, usually a version of these options: save for a specific purchase, build wealth or save for retirement. Next they will ask age and income, followed by a short series of questions regarding risk tolerance. For example, “If the market dropped 15% in one day, what would you do?” Answer options are usually a derivation of: sell everything, reallocate, or buy more.

Based on these basic questions, the robo service creates a risk/return profile for the investor. Fein argues that this is doesn’t paint the full picture and therefore can be inaccurate.

As Fein states, “Robo-advisers also have been criticized for ignoring key information relevant to a user’s investment needs, such as the user’s contribution and withdrawal schedule, dependents, other sources of wealth, monthly expenses, tax situation, anticipated expenditures (such as college tuition), and the like.”

Robos Don’t Act in the Client’s Best Interest

Part of the personalization claim of robo-advisers is their assertion that they are unbiased and they invest and reallocate in the client’s best interest. Fein has found that these services often do not behave altruistically or beyond the errors of any human financial adviser. It is human financial advisers who are programming the algorithms that decide how the robo-adviser will invest. Automatic rebalancing can perhaps be offered by a robo-adviser in an unbiased fashion, although each robo-adviser uses different “rebalancing bands” to determine how much assets may drift before they are rebalanced. Looking at robo-adviser transactions, Fein discovered that “robo-advisers use affiliated brokers, custodians, clearing firms, or other firms from which they receive compensation.” The affiliations the robo-advisers maintain make it very difficult for them to operate in a fiduciary capacity.

To maintain their minimal costs for investors, robo-advising portfolios often utilize an affiliated broker. This may provide an advantageous relationship to the robo-adviser and the broker, but may not guarantee the lowest transaction rates. Fein’s research of user agreements found that this caveat regarding achieving the lowest transaction rates is even stated. Other agreements mention that the robo-advisers may participate in cross-trades “that have resulting conflicts of interest,” according to Fein. Some have a biased interest in particular security recommendations, as is the case with Vanguard Personal Advisor; they use primarily Vanguard funds, but mention they can use funds from other fund families if they feel they’re a better investment option.

Contractual robo agreements state that investors are responsible for investment decisions being in their best interests, not the robo-adviser. The firms providing robo-advising services also seek to reduce their legal liability by requiring the investor to indemnify them; ultimately, Fein says, these firms do not want to be perceived as being under a fiduciary responsibility to the client.

Robos Don’t Necessarily Cut Costs

Many robo-advisers state that they are low-cost and even, in some cases, cost-free. While this statement may be true in reference to commissions and transaction costs, it’s rather misleading to use the word “free.”

Some robo-advisers collect no direct fees from users, but often they receive other forms of compensation. These methods may not always be transparent to investors. According to Fein, clients bear the cost of brokerage, transaction and other expenses, which may come from affiliated brokerages and the clearing firms handling the actual holdings. Embedded fees are also a part of the investment products that robo-advisers use, which are revealed in user agreements if they are read. For example, robo-advisers may not charge a commission on transactions and trades, but the investor must still pay the exchange-traded fund (ETFs) or mutual fund expense ratios.

According to Fein, robo-advisers “do not appear to offer their services at less cost than mutual funds...[or] to be less costly to the investor than ERISA 401(k) plans.” She believes that the DOL’s assertion that “investment advice from a robo-adviser [is] ‘free’ or at a ‘low cost’ is not well-founded.”

Conclusion

The discussion points of this article have been presented in an attempt to provide more context and to give investors a more informed perspective on robo-advisers and their businesses. For some investors, robo-advisers offer a relatively easy investment vehicle; however, the claims that robo-advisers use to entice clients are not always well-founded. The ultimate decision as to the appropriate long-term investing strategy is always, rightly, in the investor’s court.

Robo-advisers are not a one-stop shop for long-term investment. They are best used as one tool in a box of resources, and caution should especially be taken with robo services that are less opaque as to the securities they invest in. Keep in mind that robo-advisers limit their offerings to serve a certain clientele.

Robo-advisers are so new that their ultimate advantages and disadvantages are currently hard to pin down. But in time they will most likely become an important investment vehicle for specific applications, so understanding how they operate, and what their possible pitfalls are, is key to being a successful individual investor.