Tag Archives: history

Robo Advisors Won’t Die As Fast As High Fee Human Advisors

Michael Kitces has a very good post up discussing some of the big trends in the Robo Advisor space. Michael notes that the robo growth is falling off fast and that this could be a sign that the trend here is beginning to dry up. He ultimately concludes that the biggest winners here are the companies augmenting human advisory services with the benefits of the robo technology: “advisor platforms are quickly seeking to build or acquire it to provide it to them, and the tech-augmented humans are increasingly pulling ahead of both their robo and human counterparts.” I think this is pretty much dead on. When I wrote my original piece on the Robo Advisors I said that the endgame here was clearly some combination of human advisors and technology.¹ After all, a robo “advisor” isn’t really an advisor at all. It can’t risk profile you correctly, it can’t know your intricate financial details, it won’t help you stick with a plan when it looks like the world is falling apart, it can’t provide the appropriate financial planning needs, etc. As I’ve stated before, these services are just Robo Allocators. And if you ask me, they aren’t doing anything all that sophisticated so the value proposition is limited from the start. Let me explain why I believe this realization is driving the slowdown in growth we’ve seen. 1 – Robos Build Fancy Looking and Expensive Versions of the Vanguard Three Fund Portfolio. One of the points I highlighted last year was the fact that the Robo portfolios all mimic some version of the Vanguard Three Fund Portfolio . That is, they take 6-20 positions and build something that almost perfectly resembles the specific allocation of the much cheaper Vanguard portfolio. The result is that you’re adding the management fees of the Robo on top of the expense ratios of the underlying funds, resulting in a high fee version of something very simple: (WealthFront Moderate Profile vs. Vanguard 3 Fund Portfolio) (Betterment Moderate Profile vs. Vanguard 3 Fund Portfolio)¹ As you can see, the performance is nearly identical. And if you can rebalance once a year and harvest some losses on your own it becomes difficult justifying a management fee for this. This is ultimately the biggest impediment to Robo Advisor growth. As more people use these services they’re realizing that what they’re getting is little more than a really simple passive portfolio that they can easily build on their own without the Robo middleman. There are some side benefits like tax loss harvesting and the automation of the rebalancing/reinvestment, but it’s not going to be worth it for anyone who has the time to look at their portfolio a few times a year (which is everyone). 2 – The Stock Market Scare Exposed the Same Old Flaws in Traditional Portfolio Theory. The Robo advisors all pride themselves on using “Nobel Prize winning” approaches to investing. But this approach has also exposed the same old flaws we saw during the financial crisis – most portfolios constructed using Modern Portfolio Theory will have highly correlated equity heavy allocations. Even more “balanced portfolios” constructed using Modern Portfolio Theory are not really very “Balanced” at all from the perspective of drawdown risk. One of the key points I highlight in my new paper on portfolio construction is the need for balanced risk in a portfolio. And when you measure risk by the academic notion of volatility, you tend to arrive at portfolios that are always equity heavy which is the case with the Robos. This creates a temporal conundrum and behavioral problem for most asset allocators – are you willing to go through potential periods of substantial unrealized losses in exchange for the potential that you will make it all back “in the long-run”? The cause of this is the fact that stock heavy portfolios are always overweight purchasing power protection (reaching for gains) at the expense of permanent loss protection (protecting against downside exposure). This is because bear markets will expose a traditionally “balanced” portfolio like a 50/50 stock/bond portfolio to excessive permanent loss risk since 85%+ of the downside comes from the stock component. That is, even a 50/50 stock/bond portfolio is not balanced at all as the majority of the negative volatility comes from the 50% stock piece. The two portfolios mentioned above are the moderate profile portfolios for two of the dominant Robo firms and these portfolios will undergo 40%+ declines in a bear market like the 2008 crisis. (Betterment Moderate Portfolio Drawdowns) These are extraordinary drawdowns for a moderate risk profile. To put this in context, a moderate Robo portfolio is designed in such a way that it will take on almost 85% of the downside risk of the S&P 500 during bear markets. That’s quite the rollercoaster ride for most people and not the level of certainty they want from their savings. I’ve referred to this as a major flaw in Modern Portfolio Theory, but I suspect that the deficient risk profiling process in the Robos is compounding the problem by placing the vast majority of their clients in portfolios that are exposed to substantial negative volatility. The cause of this is simple – they’re trying to be fiduciaries who serve the best interests of their clients when the reality is that they are asking 4-5 insufficient questions in the process of risk profiling and then placing you in a very general allocation that could be wildly incorrect because they don’t actually know their clients. The result in many cases is an overly aggressive and insufficiently customized portfolio. I suspect that these are the two primary drivers of the slowdown in Robo growth. But despite the flaws in these approaches, I have to disagree with Michael to some degree. I don’t think the recent weakness in asset flows are the death of the Robos. I suspect something bigger is happening and these firms are merely pushing the human advisory space in its logical direction – towards a much lower fee platform. After all, while I am here criticizing a portfolio that costs 0.28%-0.38% (Betterment’s and Wealthfront’s all-in costs on portfolios over $100K) I would be remiss if I didn’t also clarify that I think it’s absurd that most advisors still charge 1% for constructing something that is usually the same. So no, this isn’t the end of the line for the Robos. In fact, it’s all just the beginning of a long-term decline in human advisory fees. And the combination of these new technologies with lower human advisory fees will create a nice blend of real advisory services with low-cost investing. But we’re not there yet. Human advisory fees have a long way to fall and I suspect that the human advisory space will contract substantially more (in relative size to the Robo space) before all is said and done. ¹ – See, Should You Use an Automated Investment Service? ² – In order to perform these longer backtests I used the JPM GBI for the global bond piece that Betterment uses.

Using Economic Indicators To Time The Market

If you pay attention to the financial market news, you may have noticed a lot of attention being focused on the slowing US/Global economy and the implications it has for financial markets. Just do a search on ‘slowing global PMI’ and watch the hours waste away. Basically, the US/Global economy is slowing which means recession is right around the corner, which means financial markets will tank. That seems to be the predominant bear case now, or one of the many. There is some merit to this argument. The worst market downturns occur during recessions. The trick is that you need to know that before the recessions actually happen. In this post, I’ll point you to some research in this area, then focus on just one indicator that does a decent job of forecasting recessions and how it can potentially be used as a market timing indicator on its own. To try and predict recessions, there are all kinds of metric and techniques used (ECRI, Conference board indicators, etc.). You can spend many many hours looking at all of these and their histories. Believe me. Me and an investor friend have spent tons of hours looking at and studying these. And the history of indicators predicting recessions is mixed to say the least. But I won’t bore you with that here. Instead, if you’re interested, you should read this by Philosophical Economics (which I’ll call PhiloEcon) and some of the linked posts in that piece. There is some incredible work and insight in the post (pretty much anything he/she writes is worth your time). Turns out that historically, the change in the trend in unemployment rate has been a pretty good indicator of recessions. It has also been decent at signaling when the economy has come out of a recession. Below is the key chart. Not bad. When the unemployment rate crosses above the 12-month moving average to the upside, a recession is likely coming, when it crosses below the 12-month moving average, the economy is out of the recession. Can this be used to time the stock market? And does it work better than other market timing indicator such as the popular 200-day simple moving average of prices? Basically, yes. You can read through the post and see how using the unemployment rate improves returns and risk over buy and hold and a trend following system. As usual, I wanted to run some numbers myself. Let’s take a look at that. I first wanted to see how the unemployment rate indicator (UI from now on) performed on its own versus buy and hold and other trend indicators, specifically the 200-day SMA and 12-month absolute returns. I also wanted to use real investable products, including fees. I looked at returns going back to the beginning of 1999 through April 26, 2016, for the S&P 500 ETF (NYSEARCA: SPY ), which fortunately started in 1993. This time period encompasses two of the biggest market downturns in history. I compared buy and holding the SPY versus using the 200-day SMA, 12-month total return, and the UI to exit and enter the market. When the timing systems are out of the market they are not invested, i.e. 0% cash return. Below are the results. Very impressive. This simple indicator delivered returns 3.4% per year greater than buy and hold and more than doubled risk-adjusted returns. It also beat both other timing systems by a long shot. In addition, the simple UI system produced fewer false positives and traded a lot less. Definitely worthy of consideration. You can probably see where I’ll be going next with this. In some following posts, I’ll look at adding a risk-free asset to the mix during times of risk-off, combining the UI with other indicators (which is what PhiloEcon has done in the GTT system), and adding some global risk assets to the mix. To give you a preview, they are all better than what I’ve shown here. Finally, before I end this post, what is the unemployment indicator saying right now. Does it support the bear case I noted in the opening paragraph. No, it doesn’t. The current unemployment rate is 5.0% where the 12-month moving average stands at 5.2%. If the unemployment rate increases by 0.1% each of the next two months (April and May – remember the reported unemployment rate is for the previous month), then the rate would cross above the 12-month moving average. We won’t find out until the May unemployment rate is reported at the beginning of June. And we’ll know this week what the April rate is. This seems unlikely but you never know. The FOMC’s own projections don’t support a change but they are notoriously poor forecasters. Others think that more realistically the end of the year would be the time frame we could possibly see a trigger. But there is no need to forecast to use the UI system. For now, if you were using this system it would be risk on still. In summary, historically, the change of trend in the unemployment rate has been a good signal to time the market. Better than the two most popular trend indicators around.

Do You Have Rally Envy Or Bear Market Anxiety?

For those who have paid attention, the last actual bond purchase by the Federal Reserve occurred on December 18, 2014. Why does the date matter? For one thing, research demonstrated that the expansion and manipulation of the Fed’s balance sheet (i.e., QE1, QE2, Operation Twist, QE3) corresponded to 93% of the current bull market’s gains . 93%! Secondly, stocks have struggled to make any tangible progress since the central bank of the United States ended six years of unconventional monetary policy intervention roughly 18 months ago. If you subscribe to the notion that the Fed’s balance sheet is – for all purposes and intents – the primary driver for asset price inflation, you probably have a substantial money market position already. Perhaps you have moved 20%, 25% or 30% to cash or cash equivalents. On the other hand, if you simply believe that low interest rates alone “justify” exorbitant valuation premiums , you may be content to ride out any volatility in an aggressive mix of stocks of all sizes and higher-yielding instruments. Myself? I believe that recent history (20-plus years) as well as long-term historical data (100-plus years) favor a defensive posture. For instance, in the 20-year period between 1936-1955, there were four stock bears with 20%-40% price depreciation and ultra-low borrowing costs near where they are today. Interest rate excuses notwithstanding, every prior historical moment where there were similar extremes in stock valuations – 1901, 1906, 1929, 1938, 1973, 2000, 2007, stocks lost more than 40% from the top. There’s more. Since the mid-1990s, peak earnings have been associated with eventual market downfalls. Near the end of 2000, the S&P 500 traded sideways for nearly a year-and-a-half; shortly thereafter, the popular benchmark collapsed for a top-to-bottom decline of 50%. In the same vein, the S&P 500 had been in the process of trading sideways for approximately 18 months near the end of 2007; thereafter, U.S. stocks lost half of their value alongside a peak in corporate profits. With corporate profits having peaked near the tail end of 2014, and with the S&P 500 range-bound since the tail end of 2014, is it reasonable to suspect that history might rhyme? Click to enlarge In light of what we know about valuations and corporate debt levels , bullishness on markets moving meaningfully higher would depend heavily on three items: (1) Profits per share must improve in the 2nd half of 2016 alongside stability in oil as well as improvement in the global economy, (2) Corporations must continue to borrow at low rates to finance the purchase of stock shares that pensions, retail investors, hedge funds and institutional advisers are unlikely to acquire, and (3) Corporations must have the access to borrowed dollars in an environment where lenders do not choose to tighten their standards. On the first point, there have been exceptionally modest signs that the euro-zone economy is picking up marginally. On the flip side, emerging market economies, particularly China and Brazil, are still deteriorating, while Japan appears to be coming apart at the seams. The net result? I expect a wash. It is difficult to imagine genuine profitability gains based on a global economic backdrop as murky as the one we have at present. That said, companies will still want to enhance their bottom lines. The only way that they’ve been able to do it since the 3rd quarter of 2014? Borrow money at low rates, then acquire stock to lower the number of shares in existence. Not only does the activity boost earnings per share (EPS) when there are fewer shares, but the reduction in supply makes shares more scarce. Scarcity can artificially boost demand. However, what would happen if it became more difficult for corporations to tap the bond market to finance buyback desires? Indeed, we may be seeing the earliest signs already. Consider a reality that the most recent data on commercial and industrial loans (C&I Loans Q4 2015) revealed where lending standards tightened for the third consecutive quarter. Some research has even shown that when there are two consecutive quarters of tighter lending standards, the probability of recession and/or a significant default cycle increases dramatically. (And we just experienced three consecutive quarters.) It is equally disconcerting to see how this has played out for financial stocks where banks tend to be exposed to “undesirable” debts. There’s no doubt that the Financial Select Sector SPDR ETF (NYSEARCA: XLF ) had a monster bounce off of the February 11 lows. On the other hand, the downward slope of the long-term moving average (200-day) coupled with an inability to gain genuine traction over the prior nine months is unhealthy. The same concerns exist in European financial companies via the iShares MSCI Europe Financials Sector Index ETF (NASDAQ: EUFN ). One thing appears certain. With respect to the stock market itself, quantitative easing (QE), zero percent rate policy (ZIRP) and negative interest rate policy (NIRP) primarily enticed companies to act aggressively in the purchase of additional stock. “Mom-n-pop” retail? They’re not biting. Neither are pensions, “hedgies,” money managers or other institutional players. Only the corporations themselves. So what would happen if corporations – entities that have already doubled their total debt levels since the end of the Great Recession – significantly slowed their borrowing? Don’t discount it! Executives may already be growing wary about their corporate debt levels; they may already be troubled by the underperformance of stock shares after having spent billions on buybacks. In fact, a borrowing slowdown could occur because access to credit becomes more difficult. Personally, I recognize that the Fed is unwilling to sit on its backside if a bearish downtrend escalates. In fact, I have already laid out the scenario as I anticipate it occurring; that is, we travel from 4 rate hikes in 2016, to 2 rate hikes to no rate hikes to QE4 . Some do not believe that a fourth iteration of quantitative easing would stop a bear in its tracks, but I think it could reflate assets significantly. (And that’s not an endorsement of QE, only a recognition of its success at fostering indiscriminate risk taking in the current cycle.) On the flip side, I cannot say when the Fed will resort to QE4. Most likely? They’d hint at a shock-n-awe policy action near 1705 on the S&P 500. Until the Fed gives financial speculators what they want, though, I plan to maintain an asset mix for clients that is more defensive than usual. Could you have any exposure to Vanguard Total Stock Market ETF (NYSEARCA: VTI )? Sure. Nevertheless, you’ll need 25% in cash/cash equivalents to take advantage of a bear-like mauling. Click here for Gary’s latest podcast. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.