Robo-advisors: Much Ado About Nothing?

I just finished reading an article about a recent debate between noted financial advisor Ric Edelman and Adam Nash, CEO of robo-advisor Wealthfront. Interestingly, Edelman suggested that robo-advisors would put many financial advisors out of business.

My position is simple. If you are truly a wealth manage, providing more than just asset allocation/money management services, you should not have a reason to worry. The high net worth sector needs, and wants, more than just money management services. Studies have consistently shown that the HNW sector wants integrated wealth management, including wealth preservation services such as estate planning, asset protection and retirement distribution planning. That’s one of the main reasons I hold myself out as a wealth preservation attorney, as I offer that package of services.

If you hold yourself as a wealth manager, but only provide portfolio management services, then you may have reason to worry. If robo-advisors can prove that they provide meaningful and consistent money management services at a significantly lower rate, then they may in fact have created a better mousetrap for those who only need such services.

Just as the bear market of 2008 was a true test for many financial advisors, I think the true test of the robo-advisors will be when the market encounters it next significant downturn, or “black swan.” Given the length of the current bull market, the recent volatility in the markets, and the suggestion of a pending increase in interest rates, that test may be sooner than later.

I’m not sure what algorithms and concepts robo-advisors use, but the fact that they are computer driven means the potential for “garbage in, garbage out” issues remains real. The same issues that plague current commercial asset allocation/portfolio optimization software programs may well affect robo-advisors.

One of the services that I provide is a forensic analysis of computer prepared asset allocation/portfolio optimization reports. During one of my former positions, we worked with a well-known company to create a proprietary asset allocation program for the company. Based on what I learned during that time, I realized that such programs will always have an inherent instability and a propensity to often make recommendations that are either counter-intuitive at best, or simply flat out improper.

When I prepare a forensic analysis, I use four proprietary metrics, including the Active Management Value Ratio™, which I have made publicly available through posts on this web site. But in many cases, one does not need metrics to detect errors in asset allocation/portfolio optimization recommendation.

One of the best cases of this was a situation where a widow had a plan prepared. One of the questions on a questionnaire she was asked to complete asked if she had a need for current income. She properly marked “no,” as her current portfolio provided a nice stream of income. However, the computer program misunderstood her answer and essentially recommended that she significantly increase her holdings in growth-oriented equity mutual funds with little or no income. Fortunately, I was able to point out these problems to the widow and her attorney before any changes were made to her portfolio.

So, I am suggesting that financial advisors may take advantage of the robo-advisor buzz and offer to review the robo-advisors recommendations and performance and use it as a marketing opportunity. I know a couple of financial advisors who have already offered such services to former clients for free in hopes of demonstrating the worth of their services in comparison to robo-advisors. Since most robo-advisors are offering their services at significantly reduced rates, e.g. 25 basis points, the financial advisor will still have to deal with that issue.

The point is that robo-advisors have yet to be time tested, so their true worth is still suspect. Just like so many 401(k) plans that offer investment options that are far from prudent, both in terms of fees and performance, robo-advisors who provide imprudent investment management, albeit at a reduced price, are worthless and clearly not in the best interests of their clients. Only time will tell.


About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors on sound, proven investment strategies that will help them protect their financial security.
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