Robo-advisers fail to keep risk levels constant: expert
Most investment industry watchers believe robo-advisers are an important new way for investors to gain low-cost access to portfolios made up entirely of exchanged traded funds. The same goes for the growing number of model portfolios being created in-house by the country’s ETF providers.
But Mark Yamada, the chief executive and president of PUR Investing Inc., a Toronto-based portfolio manager and software developer, believes many of these solutions are flawed when it comes to what is most important to investors: managing risk.
“Most robo-advisers and model ETF portfolios use modern portfolio theory and offer very simple, conservative approaches that have a fixed asset mix,” Mr. Yamada said during a recent interview. “It’s easy to understand why. Lots of people accept it, but it doesn’t always work very well.”
Rather than maintain a fixed percentage asset mix — for example, 60% equities and 40% bonds — Mr. Yamada’s strategy focuses on maintaining a client’s risk objective at a constant level.
The approach, which assesses the standard deviation of each asset to find an optimal mix, is the foundation of Horizons ETFs Group’s model portfolio program launched last year. It is also receiving growing interest from some of the country’s larger institutional investors, and, Mr. Yamada said, at least one robo-adviser looking to launch in Canada in the near future.
“Most 60/40 portfolios force the adviser to rebalance the asset mix regardless of the risk in the marketplace, but that’s just stupid,” he said. “If the risk in the market increases, we dampen the risk in the portfolios, so that risk is constant.”
For Horizons, Mr. Yamada has created six “constant risk” portfolios using a computer algorithm that standardizes risk ratings to distinguish them from each other.
The fixed-income model portfolio, for example, has a risk number of five attached to it that indicates two likelihoods.
The first is that it is expected that fundholders will get at least all of their money back plus inflation with a 95% probability over a time horizon of five years; and the second is that the maximum drawdown in any 12-month period during that fiveyear time frame is expected to be 5%, again with a 95% probability.
Likewise, the alternative model portfolio with a risk number of 18, has a time horizon of 18 years, whereby investors get at least all their money back plus inflation 95% of the time, and the maximum 12-month drawdown is 18%, 95% of the time.
“There is always a chance you will lose more, but if you are rebalancing to a fixed risk level as opposed to a fixed asset level, you improve your chances tremendously,” he said. “For most retail investors, the definition of risk is losing money.”
Mr. Yamada admits that his approach is different from what many investors are used to, but the more “sophisticated approach” to managing risk makes sense for those looking to protect their portfolios from huge swings in performance.
“Everybody is concerned about volatility and very few people have any answers about what to do with it,” he said, “Our approach offers a better answer to the question, ‘How are you going to handle higher volatility moving forward?’ ”