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The Rise of the Robo-Adviser

Written By Briton Ryle

Posted July 16, 2014

If you thought the investment market has reached its saturation point, with no room remaining to introduce anything new, you’d be underestimating the creative talents and business savvy of young tech entrepreneurs.
Just when you thought you’d seen it all –from structured exchange traded products to custom-designed funds– along comes a new investment service to give you even more to shack 80s robotic banker toy

Until now, almost every investment instrument could be slotted into one of two broad categories – actively managed or passively managed. While actively managed instruments have experienced professionals making all the decisions on what to hold, when and how much, passive instruments are predefined to track an index, a commodity, or a group of stocks with the slightest of tweaking by managers quarterly or annually.

Thanks to the creative minds of techies whose gerbil-like brain cells never stop treading the idea mill, there now exists a new category of investment products that are neither passive nor actively managed by people. They are managed by computers.

The trading decisions made by these “robo-advisers”, as they are called in keeping with the forward-looking futuristic mindset of their young sci-fi inspired creators, are based on mathematical algorithms built into computer programs. All buy and sell decisions are thus automated according to a pre-set flow designed to meet a specific purpose or objective.

While designed primarily for employees of tech companies in Silicon Valley and elsewhere, some investment firms offering robo-adviser services are already eyeing the general marketplace for potential clients from institutions to individual investors. So we can expect to hear more about them over time.

But are robo-advised products and services for you? It is hard enough for experienced professional advisors to consistently turn a profit from active portfolio management. Can an autonomous computer program fair any better?

One Example of Numerous Applications

Over the past year or so, tech start-ups have been attempting to tap into a rapidly growing segment of new wealth – the employees of burgeoning tech companies in Silicon Valley and across the nation.

With a neverending parade of IPOs marching into the public arena over the past few years, thousands of young technicians, developers, marketers and other personnel are being handed stock option packages that balloon in size overnight.

Naturally, after a successful IPO, the temptation exists to sell a vast portion of those options and cash out part of their bonuses – generally a smart move given the usual pattern of price plunges immediately following an IPO.

But this flood of selling can be extremely detrimental to a stock’s price, as millions of shares are unloaded onto the marketplace by employees all at once, even when the company imposes a temporary “lockup” period during which employees are not permitted to sell their shares. If anything, all these lockup periods do is postpone the flood of selling to a later date.

So one tech start-up has devised an automated portfolio management system that will carefully and systematically sell employees’ shares over an extended period to allow the stock price to swallow large sell orders in small, bite-sized pieces, allowing the stock price to rebound a little after each portion of the sale is made.

Think of it like watering your plant slowly enough to allow the soil absorb the water at its own rate, preventing the water from spilling over when dumping too much in all at once.

This “single-stock diversification service” offered by investment start-up Wealthfront Inc “takes the guesswork out of sound, long-term investing through effortless automation”, their website explains their advantage.

Yet this is just one of many applications that robo-advisor trading systems can be programmed to execute. In addition to its “single-stock diversification service”, Wealthfront also manages “a diversified, continually rebalanced portfolio of index funds on [clients’] behalf at a very low cost and in an extremely tax efficient manner” – all based on computerized algorithms designed under the guidance of “a team of world-class financial experts, led by Dr. Burton Malkiel, renowned economist and author of A Random Walk Down Wall Street, with some of Silicon Valley’s best technology talent”.

In brief, then, the main advantages of these computerized trading programs are efficiency of trade execution and portfolio rebalancing at minimal costs, which can be programmed to follow a customized trading method or strategy.

Extending these services to employees of recent IPO debutants is just one of many areas where such robo-adviser services would be readily welcomed, since these automated algorithms can be tailored to follow specific instructions, allowing individual companies to control the flow of selling by participating employees who have voluntarily opted into the program.

But Wealthfront, already with over $1 billion under management – along with other competitors like Betterment LLC and Personal Capital Corporation each with half a billion under management – are actively expanding their robo-advisor autonomous investment management services to the broader investment marketplace, offering such low-cost robo-management options to all investors at large. You can bet on hearing a lot more about them.

The question is… can they be trusted?

A Question of Control

Deciding whether a computer-automated trading program should manage your portfolio depends on just one thing… control. Just how much control over your investments are you prepared to relinquish to someone else?
If you do not lay claim to any trading prowess of your own, or you simply do not have time to actively manage your portfolio, you might feel more comfortable turning over a larger degree of control to a professional manager.

But to a computer manger? Now that might be asking a little too much of us.

For an investor to be comfortable relinquishing control of their investments to a computer program would require a very detailed explanation of what precisely the robo-adviser is programmed to do in specific situations. What would it do if the market experienced a flash crash? How would it handle extended corrections down or extended bull runs up? If regular rebalancing is part of the program’s code, when will such rebalancing take place and by how much? How much say does the investor have in the program’s specifics, like stock selection and dollar-amount allocation? Or do these companies offer pre-packed funds that trade on proprietary programs whose details are not disclosed to the public?

There are dozens of questions that investors would need to ask before turning over control of their investments to a computer program. And of course, we also need to know who the people are programming the commands. What are their credentials? What is their track record of success? Remember that simply having a professional on the team is quite different than actually having them design and supervise the trading methodology.

It’s all a measure of how wide a comfort zone you have. Any new approach to investing needs to be given enough time to show what it can do – not just how it performs in an up market, but also how it performs during corrections and bear markets. While no track record is an absolute indication of future performance, a reasonable length of time in operation would at least give us a general idea of what we might expect.

We don’t want to shun something just because it’s new. But we would be wise to study it for a while before embracing it with open arms. It’s not as if we don’t have enough of other investment options that already have long histories of proven success.

Joseph Cafariello