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Robo Advisor Expected Performance and Acceptance

| | Posted in: Investing Expertise, Mutual/Hedge Funds

Does a flexible robo advisor (offering automated, passive investment strategies tailored to investor situation/preferences) perform well in comparison to mutual fund/stock portfolios they might replace? If so, what inhibits investors from switching to them? In their November 2016 paper entitled “Robo Advisers and Mutual Fund Stickiness”, Michael Reher and Celine Sun compare actual mutual fund/stock portfolios held by individuals to Wealthfront robo advisor portfolios constructed by assigning weights to 10 exchange-traded funds based on investor responses to questions about financial situation and risk tolerance. The robo advisor portfolio construction process includes a critique of original portfolio diversification, fees and cash holdings. They focus on stock, mutual fund and ETF holdings in retirement (non-taxable) portfolios. They project net portfolio performance at the asset level based principally on the Capital Asset Pricing Model (CAPM, alpha plus market beta) of asset returns. They group findings by: individuals who manage their own portfolios versus those who rely on mutual funds; and, individuals who choose to set up robo advisor accounts versus those who do not. Using original investor portfolio and corresponding robo advisor portfolio holdings collected during mid-January 2016 through early November 2016, fund loads and fees as of September 2016, and monthly returns for all assets and factors as available since January 1975, they find that:

  • Robo advisor portfolios are substantially more diversified than corresponding original portfolios. The diversification gain is less pronounced for original portfolios relying on mutual funds.
  • Most original portfolios have higher expense ratios than corresponding robo advisor portfolios.
  • Most robo advisor portfolios have a higher expected net Sharpe ratio than corresponding original portfolios, driven mostly by a lower expected volatility. Specifically, the median difference in expected Sharpe ratios is 17% higher for robo portfolios than for original portfolios.
  • Regarding attractiveness of robo advisor accounts:
    • In general, critique that an original portfolio is very risky significantly increases the likelihood an investor will set up a robo advisor account.
    • Among investors who rely little on mutual funds, the likelihood of setting up a robo advisor account increases with the degree to which the expected Sharpe ratio for the original portfolio is below that of the corresponding robo advisor portfolio.
    • Investors who rely heavily on mutual funds are significantly less likely to set up robo advisor accounts than other investors, regardless of expected Sharpe ratio gap between original and robo advisor portfolios. Trust in investment managers recommending mutual funds and costs of fund liquidation (back-end loads) may account for this reticence. Specific critiques of original portfolio diversification and fees mitigates this effect.

In summary, evidence indicates that robo advisors may be most attractive to individual investors who pick their own stocks and thereby have fairly undiversified portfolios.

Cautions regarding findings include:

  • Considerable evidence indicates that CAPM, central to the expected portfolio performance comparison in the paper, is not be a useful predictor of asset returns (see, for example, “Why Extra Risk Earns No Extra Reward?” and “Forget CAPM Beta?”). In other words, comparison of expected performances between original and corresponding robo advisor portfolios may not be meaningful.
  • Data are inception-to-date, so start dates for beta calculations vary across assets, thereby potentially confounding comparisons.
  • The Wealthfront robo advisor ETF weighting algorithm may be fitted to some of the same historical data used in portfolio tests, thereby impounding positive bias in robo advisor portfolio expected performance.
  • As noted in the paper, the original portfolio sample (median investor age 34 and median account size over $400,000) may not be representative of individual U.S. investors overall.
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