Skeptical of Robo-Advisors? You Should Be…

I’m an information hog. I love to read about the new technologies breaching the financial services industry. In fact, I usually request a demo of financial software if I think it’s unique. I have requested demo’s from JemStep, Schwab Intelligent Portfolios, FutureAdvisor, Motif Investing, Betterment, and so on. I wanted to understand how their software works and how portfolios are constructed. Many times the individuals that I spoke with couldn’t give me a very good answer as to how they construct their portfolios besides providing me with a blanket answer of diversification. Many state that their investment philosophies are backed by big names like Burton Malkiel, but fail to give me an understanding of how portfolios are chosen or how risk is measured. As a result, I made the decision to not provide a Robo option to prospective clients of my firm, but that may change.

Yesterday, I received an email from a small Robo-Advisor/Risk Assessment firm named RiXtrema. RiXtrema came out with a robo-advisor for advisors called BioniX. It looks at risk in a much more reliable manner. For instance, take this excerpt from the RiXtrema White Paper, which I highly suggest you read if your money is invested with a Robo-advisor.

“Robo-advisor methodologies are based on mean-variance optimization, which focuses on trailing variance as a measure of risk. Trailing variance is calculated from relatively recent history of the financial markets, usually a few years. Variance in financial models is simply an average squared difference between the average return and return on every date observed over some historic period of time. Thus it should be clear that when [the] market is trending up like we have seen over the past few years, the average return is positive and deviations from that average are relatively small. That is why in periods of prolonged market tranquility, trailing risk measures have dramatically understated market risk.”

Not to make things technical, but if you have some sense of what that statement means, it should give you pause with the current volatility in the market. The majority of Robo-Advisors will manage risk in this way. To follow up with another great excerpt from the white paper:

“In addition to the problem of understatement of risk prior to a crisis, variance based measures overstate risk following it. You can see that risk in our chart keeps climbing all through 2009 and, in fact, keeps climbing through 2011. As a result, investors that go to robos after the crisis will get portfolios that are now excessively light on stocks. Mean variance algorithms can be thought of as ‘buy high sell low’ strategies around crisis events, which is the opposite of what investors want. Imagine if an advisor had suggested that clients load up on risky assets prior to the Lehman collapse, but then after the collapse in 2009 started putting everyone in bonds. That would be precisely what should not happen, but that is what existing robo technologies are set to do. It is no surprise that the Fed no longer uses Value-at-Risk (essentially same as trailing variance) when talking about systemic risk, but focuses exclusively on stress testing.”

So, you’re telling me Robo’s will buy high and sell low? Yes, that’s what it’s saying. Think of it as measuring risk on a delay. It’s like getting delayed quotes when you’re trying to trade intraday. It’s worthless and you lose money. Why would you do it? My point is that if you decide to use an automated investment platform make sure you understand how they measure risk and how it constructs portfolios based on that risk. For the past 2 years, Wealthfront portfolios have gotten murdered. Wealthfront portfolios have no Treasuries. There’s nothing in the portfolios to soften the blow. Their portfolios have stunk the place up! A person with average risk tolerance still has 38% of their portfolio in foreign plus emerging stocks or bonds. I don’t know if you noticed, but it’s been quite the shit show in Emerging Market bonds and stocks.

Stay safe and do your homework. I’ll update this post once I demo RiXtrema.