Rotman Management Magazine - - FROM THE EDITOR - In­ter­view by Karen Christensen

on the pros and cons of Robo Ad­vi­sors

What op­tions are cur­rently avail­able to some­one who wants to in­vest some of their hard-earned money?

To­day’s in­vestors have a num­ber of choices. First, they can open up a dis­cre­tionary ac­count, where they give their money to a fund man­ager who makes the de­ci­sions for them. They would just have to fill out a form, in­di­cat­ing their ob­jec­tives and risk tol­er­ance, and would then trust the fund man­ager to make de­ci­sions ac­cord­ingly.

They could also in­vest in a ‘pooled fund’ like Gluskin Sh­eff or Leith Wheeler, or deal with a full-ser­vice bro­ker. That’s the stan­dard ap­proach that I grew up with: You open up a bro­ker­age ac­count and ei­ther pay the bro­ker a fee or a com­mis­sion; then they deal with an in­vest­ment ad­vi­sor who makes rec­om­men­da­tions, which you rat­ify.

You could also open up a dis­count-bro­ker­age ac­count, where you make all the de­ci­sions and pay a very low com­mis­sion to the firm. Or, you could go even fur­ther down that path and do on­line trad­ing com­pletely on your own — which is what I do. You ba­si­cally open up an ac­count with one of the big banks or a firm that of­fers this op­tion, and you make all of the de­ci­sions. In terms of fees, you pay some­thing like $4.99 or $9.99 per trade, so the costs are re­ally low; but you’ve def­i­nitely got to know what you’re do­ing.

Fi­nally, the new­est way to in­vest is to use a robo ad­vi­sor. These are fi­nan­cial ad­vi­sors that pro­vide ad­vice or in­vest­ment man­age­ment on­line, with min­i­mal hu­man in­ter­ven­tion. Once you in­di­cate your fi­nan­cial cir­cum­stances, ob­jec­tives, in­vest­ment hori­zon and risk tol­er­ance, the dig­i­tal 'ad­vi­sor' presents you with a num­ber of sam­ple port­fo­lios to choose from. You choose one and pay the firm 50 or 55 ba­sis points to let it do the re­bal­anc­ing for you.

Are robo ad­vi­sors a dis­rup­tive busi­ness model?

The con­cept isn’t new, but I would call it a dis­rup­tive busi­ness, in the sense that they are com­pet­ing with the long­stand­ing bro­ker­age busi­nesses. What robo ad­vi­sors do

dif­fer­ently is, they use op­ti­miza­tion pro­grams with fairly de­tailed math­e­matic al­go­rithms, and they de­velop sam­ple port­fo­lios for dif­fer­ent risk tol­er­ances and ob­jec­tives.

Say you come in and fill out a form in­di­cat­ing what your tastes are, and out comes ‘Port­fo­lio X’, which is 40 per cent fixed in­come and 60 per cent equities, all in­vested in ex­change-traded funds. If the equities start to do re­ally well rel­a­tive to the bonds, the port­fo­lio will be re­bal­anced au­to­mat­i­cally.

It seems that robo ad­vi­sors might have ac­cess to more data than the av­er­age in­vest­ment pro­fes­sional — and pos­si­bly bet­ter data. Is that fair?

That may be true in some cases. I think back to 15 or 20 years ago, when I got a con­tract with one of the large U.S. bro­ker­age firms to do ex­actly this. My Rot­man col­league Ray­mond Kan and I, along with a cou­ple of other peo­ple, built sam­ple port­fo­lios for the firm — and we weren’t the first to do that, I can as­sure you. So in that re­spect, this is not new. The new piece is the ‘ Uber’- ifi­ca­tion of the process: Robo ad­vi­sors are com­pletely dig­i­tal, and that fits with the mod­ern taste for sim­ple, con­sumer-friendly dig­i­tal ser­vice mod­els.

What are some of the key ben­e­fits of this ap­proach?

I pre­dict the banks will be fairly ac­tive in this area, be­cause they’re al­ready start­ing to dab­ble in it.

First and fore­most, the costs are rel­a­tively low. To hire a hu­man to man­age your port­fo­lio, or join a pooled fund, you will have to pay a one to 1.5 per cent fee; and if you in­vest in mu­tual funds, you will pay as much as two to three per cent in fees. If you’re deal­ing with a full ser­vice bro­ker, you’ll ei­ther pay up to 1.5 per cent of your as­sets un­der ad­min­is­tra­tion or a large bro­ker­age fee. With­out a doubt, trad­ing on­line, on your own, is the low­est-cost way to do things. But as in­di­cated, you need to have the know-how to do that. Robo ad­vi­sors are next on the low end of the cost spec­trum. The ben­e­fit they en­joy is, as they get larger, there are economies of scale to be had, so they can do rel­a­tively large trans­ac­tions at lower costs.

An­other plus is that a robo ad­vi­sor takes some of the emo­tion out of in­vest­ing. Once you se­lect one that seems right for you, you can watch your state­ments and de­cide whether to stay with it or leave, but you won’t have to make de­ci­sions on a reg­u­lar ba­sis. That takes much of the stress out of the pic­ture.

What are the key chal­lenges of go­ing down this road?

Al­though the con­cept of ‘sam­ple port­fo­lios’ has been around for a long time, ac­tual robo ad­vi­sors have only been around for about eight years in the U.S. and five years in Canada. At the mo­ment, there are nine or 10 in Canada, and they all emerged in a be­nign eco­nomic en­vi­ron­ment, around 2014. Be­tween then and now, mar­kets have been pretty steady; we haven’t been through a ma­jor shake-up in the mar­ket­place, and that raises two in­ter­est­ing ques­tions. First, if things shift sud­denly, how will in­vestors who have gone the robo ad­vi­sor route be­have? The fact is, they’re not go­ing to have a full-ser­vice bro­ker hold­ing their hand. They can talk to some­body at the robo-ad­vi­sory firm, but it’s not the same one-on-one ser­vice sce­nario. Se­condly, some of the robo ad­vis0rs them­selves are fairly young en­trepreneurs who are do­ing re­ally well right now, but how would they han­dle a down­turn? Of course, it will de­pend on the strength of their ad­vi­sory team, their own per­sonal dis­ci­pline and other fac­tors.

Are any of the big banks em­brac­ing this ap­proach, or is it just start-ups?

They are. One of the big banks ac­tu­ally ap­proached me a num­ber of years ago be­cause it was think­ing about do­ing some­thing like this. I pre­dict that the banks will be fairly ac­tive in this area, be­cause they’re al­ready start­ing to dab­ble in it — and banks don’t do much dab­bling. Once they make a de­ci­sion, it gen­er­ally means that they are ‘in’. As a re­sult, we might see the banks buy­ing up some of the robo ad­vi­sors or start­ing their own, in-house.

Who is run­ning the nine or 10 that are cur­rently op­er­at­ing in Canada? I won’t use the name, but one that has ac­tu­ally done very well was started by a young en­tre­pre­neur in his late 20s or early 30s. He had some in­vest­ment back­ground, but he wasn’t a vet­eran of the in­dus­try or an ex­pe­ri­enced ty­coon. He built a young team of peo­ple who see the world through a Mil­len­nial’s lens, and that is pretty typ­i­cal of these funds.

You’ve said that port­fo­lio op­ti­miza­tion is not purely about math and data: You also need to have good judg­ment. How does that work with robo ad­vi­sors?

This is an im­por­tant point, be­cause there is al­ways a dan­ger of be­ing ‘blinded by science’ — of tak­ing a model that looks

re­ally good and just ac­cept­ing any­thing that comes out of it. Sev­eral years ago, when I was build­ing sam­ple port­fo­lios, one time I took 70 years of data and fed it into an op­ti­miza­tion pro­gram that Ray wrote, and I got some very strange re­sults: The rec­om­mended port­fo­lios had a very high weight­ing in trea­sury bills and money mar­ket funds — both of which are ul­tra-safe se­cu­ri­ties.

I soon re­al­ized what had hap­pened. Most op­ti­miza­tion pro­grams re­volve around the Sharpe ra­tio — a mea­sure of risk that looks at the av­er­age re­turn earned in ex­cess of the risk-free rate per unit of volatil­ity or to­tal risk. In ac­tual fact, there were many pe­ri­ods in which trea­sury bills had high yields. To­day, money mar­ket funds yield al­most noth­ing. You go to the bank and you get .8 per cent on a sav­ings ac­count or 1.3 per cent on a GIC. But there were pe­ri­ods in which re­turns on money-mar­ket se­cu­ri­ties were 10 or 12 per cent, and the stan­dard de­vi­a­tion of volatil­ity was very low. So, in fact, there were many pe­ri­ods in which short-term in­vest­ing had a high Sharpe ra­tio.

The point is, if you sim­ply take the re­sults that come out of an op­ti­mizer, you are likely go­ing to put way too much into safety. That’s why you need to ex­er­cise some judg­ment. You have to make sure the re­sults from the al­go­rithm are re­flec­tive of cur­rent and ex­pected con­di­tions and that they don’t re­flect some anom­aly.

Can a robo ad­vi­sor do that?

Yes, but it re­ally de­pends on who is run­ning it. Re­mem­ber, first the robo ad­vi­sor builds sam­ple port­fo­lios and then it starts at­tract­ing clients. So, the robo ad­vi­sors them­selves have to do a good job on build­ing sam­ple port­fo­lios, which means that they should be us­ing good math­e­mat­i­cal tools; but the firm’s lead­ers should also be ex­er­cis­ing some judg­ment over the re­sults.

Could you talk a bit about the con­tri­bu­tion of port­fo­lio the­ory to robo ad­vis­ing?

The no­tion of di­ver­si­fi­ca­tion — of not putting all your eggs in one bas­ket — goes back about 6,000 years, to the an­cient He­brew and Greek world. In 1952, Harry Markowitz (who even­tu­ally won the No­bel Prize) pub­lished an ar­ti­cle on port­fo­lio the­ory, show­ing how in­vestors should make their de­ci­sions. In­stead of sim­ply say­ing, ‘Don’t put all your eggs in one bas­ket’, he showed how that’s done, talk­ing about cor­re­la­tions and co-vari­ances among se­cu­ri­ties and how to build an ef­fi­cient port­fo­lio. In­ter­est­ingly enough, he never talked about se­cu­rity anal­y­sis, or try­ing to find un­der-val­ued se­cu­ri­ties. His fo­cus was al­ways on build­ing a strong port­fo­lio and find­ing the right mix that min­i­mizes risk. Eugene Fama’s re­search on ef­fi­cient mar­kets pro­vided an ‘in­dex­ing ap­proach’ to in­vest­ing that started to de­velop in the 1970s. In many ways, that was the ge­n­e­sis of mod­ern robo ad­vi­sors, which also take an in­dex­ing ap­proach. You end up with a port­fo­lio based on a num­ber of ex­change-traded funds, most or all of which match some type of in­dex.

Can you touch a bit on ac­tive ver­sus pas­sive in­vest­ing, and how they ap­ply to robo ad­vi­sors?

I’ve spent vir­tu­ally my en­tire ca­reer think­ing about ac­tive ver­sus pas­sive is­sues. Pas­sive in­vest­ing is what I just de­scribed: The no­tion of con­cen­trat­ing on your mix of safety, in­come and growth, in­stead of try­ing to find un­der-val­ued se­cu­ri­ties. As in­di­cated, there are lots of prod­ucts out there that track in­dexes, and that has be­come known as the pas­sive ap­proach. It’s not quite as pas­sive as it sounds though, be­cause you still have to de­cide which prod­ucts to buy and which in­dexes to match.

Ac­tive in­vest­ing, on the other hand, in­volves try­ing to beat an in­dex by adding value via your de­ci­sion mak­ing. War­ren Buf­fett is an ac­tive in­vestor, and so was Sir John Tem­ple­ton, who I wrote a book with. When I de­vel­oped the Easy Chair Port­fo­lio for the Toronto Star and co-de­vel­oped the FPX In­dexes for the Fi­nan­cial Post with Richard Croft, those were both based on pas­sive in­vest­ing ap­proaches.

For me, it’s been very in­ter­est­ing to ex­plore the ten­sions be­tween the two ap­proaches. I’ve al­ways be­lieved that port­fo­lios are the most im­por­tant thing for retail in­vestors, and in these cases, there is noth­ing more im­por­tant than get­ting the right port­fo­lio mix. Many retail in­vestors should not be wast­ing their time try­ing to find un­der-val­ued se­cu­ri­ties.

How­ever, for in­sti­tu­tional in­vestors — like the peo­ple who run big pen­sion plans or en­dow­ment funds — gen­er­ally, adding value over-and-above an in­dex is very im­por­tant. These peo­ple have got to come up with nice re­turns to meet their pen­sion prom­ises, so in these cases, adding value overand-above an in­dex is im­por­tant.

You hold the Chair in Value In­vest­ing at the Rot­man School, but as in­di­cated, you’re a strong pro­po­nent of in­dex­ing. How do you man­age to live in both worlds?

Ev­ery year, with­out fail, some en­ter­pris­ing stu­dent will say to me, ‘We’re tak­ing your Value In­vest­ing course, but we’ve also read your stuff on in­dex­ing; how do you rec­on­cile that?' The fact is, I’m a very strong be­liever in the in­dex­ing ap­proach for most retail in­vestors, as I’ve said. What these in­vestors should do is con­cen­trate on get­ting the right port­fo­lio mix for peo­ple, and not try to be ‘big game hunters’ and find un­der-val­ued se­cu­ri­ties.

On the other hand, value in­vest­ing can be a very suc­cess­ful long-term ap­proach. When I first started teach­ing in the early 1970s, we called it ‘fun­da­men­tal anal­y­sis’, and I based my cour­ses on the Graham Dodd ap­proach. I still be­lieve in value in­vest­ing. I don’t be­lieve that it’s the best ap­proach for most retail in­vestors, but for in­sti­tu­tional in­vest­ing, it can work very well.

If we were to face an­other mar­ket cor­rec­tion like the one in 2007-08, what role would robo ad­vi­sors play in it?

If we face an­other melt­down, it’s not go­ing to be caused by robo ad­vi­sors and it’s not go­ing to be caused by in­dex­ers. When you get a mar­ket melt­down, it’s sim­ply be­cause busi­ness cy­cles have run their course. We’ve been in a bull mar­ket for a long time now — ap­proach­ing nine years. Some­times things just run their course, and you get bub­bles, as we saw with tech­nol­ogy stocks in 1999, 2000 and 2001; and some­times you get a credit cri­sis such as the hor­rific events of 2008. Will this be caused in any way by robo ad­vis­ing or, more gen­er­ally, by tak­ing the pas­sive road? Not in my opin­ion.

What does all of this mean for the fu­ture of em­ploy­ment in fi­nan­cial ser­vices?

We know that all kinds of jobs are go­ing to dis­ap­pear in var­i­ous fields and be re­placed by other types of jobs. There is no ques­tion that the robo ad­vi­sor is an as­sault or an in­ter­ven­tion on the tra­di­tional bro­ker­age busi­ness. But we know that there are lots of peo­ple who like to shop on­line, use Uber, and spend money in other un­tra­di­tional ways. That’s where the world is headed, and it’s im­por­tant to rec­og­nize and ac­cept that. Does it mean tra­di­tional bro­ker­age busi­nesses will dis­ap­pear? Of course not. But there is no ques­tion that this ap­proach to in­vest­ing is go­ing to have a sig­nif­i­cant im­pact on the in­dus­try.

Eric Kirzner is the John H. Wat­son Chair in Value In­vest­ing and Pro­fes­sor of Fi­nance at the Rot­man School of Man­age­ment. Each year, he takes a group of Rot­man stu­dents on a trip to meet with worl­drenowned value in­vestors, in­clud­ing War­ren Buffet and Charles Bran­des.

Does this mean tra­di­tional bro­ker­age busi­nesses will dis­ap­pear? Of course not.

Rot­man fac­ulty re­search is ranked in the top 10 world­wide by the Fi­nan­cial Times.

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