How To Beat Robo Advisors at Their Own Game

To beat the robots, we must first understand them.
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The financial industry is undergoing a profound shift that looks set to continue for the foreseeable future. Not only is the fight between active and passive management is showing no signs of letting up,financial advisors staring down the threat of ETFs now have a new emerging adversary to consider – robo advisors.

Robo

Smart CFAs should not ignore this threat, but instead move to either join the trend or beat the robo crowd at its own game. But first they'll need to understand them.

The choice between between active and passive is playing out at every level of the investments business and robo advisors are just one example of that. Target lifecycle funds are another, and smart beta is a third. To combat these threats, financial advisors need to decide what their strategy is. Take the recent Ameritrade merger announcement as an instance.

Ameritrade announced last month that it would buy rival Scottrade Financial. The deal makes sense as a bet on higher interest rates – that’s a bet that is already starting to pay off thanks to the surge in bond yields since the Presidential election. Ameritrade’s acquisition of Scottrade increases its asset base and gives it more customer cash. Idle customer cash is attractive as interest rates increase because the money can be put into money markets and other overnight income-yielding investments.

Ameritrade’s action can be seen as maneuvering from a position of weakness though. Online brokers are all suffering from the slow-down in stock trading by retail investors, and increasing interest in low cost products. The shift in 403b and 401k plans to low cost alternatives, especially target date funds is emblematic of the larger shift in the overall investment of Americans. As the country’s average age increases with the Baby Boomers, we seem to be becoming more risk averse and less interested in looking for “hot stocks”.

Enter robo advisors. The robo advisor platform is really just a user-friendly version of a target date fund. It’s a low cost vehicle that promises to insulate the investor from the vagaries of human emotion. As research has shown how pitifully individual investors have performed, that proposition looks increasingly attractive.

So what’s a financial advisor to do against this backdrop?

One option is to join the robo advisor crowd – advocating for target date funds and similar investment approaches can be a lucrative strategy if it is paired with (1.) a significant increase in assets, OR (2.) the addition of supplementary services for the customer such as estate planning.

Perhaps the better approach is to beat robo advisors at their own game though. The downside to robo advisors is that they are inflexible. That opens up a lot of questions. For instance – does a passive management allocation always make sense, or is an active dynamic approach better under some circumstances? Perhaps passive management makes more sense under particular economic conditions for example. Similarly, if passive management is good in some circumstances, and active management is good in others, does it make sense to use both as a method of diversification? Should investors consider various alternative investments – even things as simple but illiquid as muni bonds? Or is the compensation insufficient historically? How are passive portfolios likely to perform as volatility increases? If everyone stampedes out of index-linked ETFs at once, that could drive prices away from fundamental values.

All of these are issues investors are concerned about, and they offer opportunities for FAs to demonstrate value. These questions are not easy to answer, but they are valuable. The chart below for instance illustrates quarterly returns to two investing strategies since 1970. The chart shows the return of a passive portfolio (blue) versus an active factor-based (red) investing strategy. The chart is ordered by magnitude of broader market returns.

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This shows that painting passive management as the “best” form of investing is too broad a brush. Passive management outperforms active factor investing 46.2% of the time, while an active factor-approach outperforms 53.8% of the time. In other words, it’s essentially a coin-toss in most periods as to whether this particular form of active management will beat the S&P. Yet, this factor investing strategy as a whole has considerably outperformed the market over time – since 1970 this specific factor investing returned an average of 1.75% per month vs. 1.04% per month for the S&P.

Granted this is one particular investment strategy, and an aggressive and volatile (i.e. risky) one at that, but it illustrates the point that passive investing and robo investors do not always win. In fact, in a recent research study I did with a colleague, passive investing’s performance vs. active or factor investing is closely correlated to economic growth. This suggests that smart investors can time their use of passive investments vs. active or factor strategies. That’s a topic for another day though.

Robo advising has picked up a lot of steam and the ball is in the court of all of the investment managers and FA’s out there when it comes to figuring out how to respond.

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Mike McDonald is a PhD in finance and a university professor in the subject. He also runs a consulting company doing work on quantitative investing, big data, and machine learning for a variety of financial firms, asset managers, institutional investors, and government regulators. Prior to getting his PhD, Mike worked for a major Wall Street bank and one of the top hedge funds. Comments, questions, and concerns are always welcome – email Mike at M.McDonald@MorningInvestmentsCT.com or visit his firm’s website at www.MorningInvestmentsCT.com

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