I was interested to read a review of Betterment in one of my favourite money/savings blogs, The Simple Dollar. Clearly early days for the reviewer, but the concept of Betterment (along with other robo-advisors) is fascinating to me. As this technology becomes more ubiquitous, and average investor age approaches the tech-savvy generations, I think conventional financial advisors could well be innovated out of business.
Suppose you’re getting started with investing, and wondering how to get started. As mentioned in my earlier Finance 101 post, choosing a financial advisor is a difficult (and ultimately unnecessary) step. From my travels to many offices of financial advisors, I note a few general themes – with no offence intended for any particular advisor:
- An advisor’s knowledge base is generally no better than a reader of the WSJ or FT. Portfolio management, securities recommendations, etc., are generally passed down from a centralised function in a head office. The advisor just assigns his clients to one or another ‘model portfolio’. Thus, if you had access to his portfolio models, you could just bypass the advisor.
- Advisors don’t generally outperform benchmarks. Again, this follows from the fact most advisors fill clients’ portfolios with benchmark-tracking securities. It’s a matter of career risk: if the advisor deviated from S&P 500 returns (or 60/40 returns, or some other common benchmark) and outperformed, he would keep his clients. If he under performs through deviating, he’ll lose his clients. If he performs at-or-around the benchmark, he’ll keep his clients. So advisors tend to be very conservative in deviating from the model, which generally tracks common benchmarks. Add in the extra fees for the advisor (and for the guys in the head office), and you’ll almost certainly underperform their benchmarks in the long-term. Aside: an honourable mention to those advisors I have met who view themselves as long-term asset class allocators, rather than security selection experts; they do tend to outperform benchmarks through tactical allocation to asset classes (such as alternatives) that really do help.
- The best reason to have an advisor: handcuffs. Advisors have a great psychological role, particularly for folks who have very little knowledge of financial markets, and very little desire to learn about the swings of security prices. Essentially the advisor becomes the ‘face’ of the financial markets for his client: when markets crash, he’s a bad guy; when markets rise, he’s a hero. Most importantly, the advisor keeps the client invested during these swings (handcuffs).
There’s very little of the above that can’t be addressed by a service like Betterment. In particular:
- Ease of use. Seems to me the service utilises sensible allocations (although just equity/bonds, see below) that require very little understanding of the user. Great for folks with money to invest, but clueless how to begin.
- Instruments used = cheap ETFs. So tracking error to the benchmarks will be minimal. They use least-cost ETFs to implement their ‘model portfolios’.
- Quasi-handcuffs. I say quasi, as it’s likely easier to liquidate your portfolio in tough markets with a group like Betterment than with an advisor. The advisor will also actively attempt to dissuade you, whereas the customer service team at Betterment might not be as forceful. But overall, the idea of sending your money away to be managed helps the client stay removed from the daily ups and downs that may cause distress and poor decisions.
- Costs = low. The absolutely most-insane part of financial advisory is the ridiculous fees advisors receive for using certain products. So, on top of paying (say) 1-1.5% of AUM p.a. to the advisor, he may allocate your portfolio towards products that pay him an extra rate – I’ve seen trailing commissions between 0.25% – 2.5% of AUM p.a. for advisors. The ETFs used by Betterment average about 0.2%, and their fee ranges from 0.15% – 0.35%. You’ll be way better off, from a cost perspective.
OK, where could Betterment get better?
- More diversification in the portfolio. The model portfolios allocate between equities and bonds. There are a lot more inexpensive ETFs out there, which access asset classes/strategies that bring better portfolio risk/return characteristics. For example, they’re very much attuned to the value anomaly (they allocate specifically to value equity ETFs), but not to the momentum anomaly. I imagine the portfolio options will expand someday.
- Tactical allocation. In particular, I don’t agree with the idea that bond ETFs are universally lower-risk than equity ETFs. Especially with yields this low. I don’t see info on the Betterment website whether their model portfolios take yield levels (or indeed, earnings yields for stocks) into account when allocating.
- Risk of over reliance on Modern Portfolio Theory. It’s a bit technical, but using MPT for portfolio allocations has a couple major downsides: unstable allocations and corner solutions. Betterment writes they use Black-Litterman (BL), combined with some downside-protection approach. I like this, but BL in particular can let in a lot of manager view: on the plus side, this would allow (for example) a view that bonds are likely to under perform in future; on the minus side, too much shading the market consensus (or that expected returns are equal to some constant) means more divergence from benchmark results. Are you looking for truly active management? I’m not sure.
In sum, I’m excited to hear how Betterment and the like grow over time. For tech-savvy generations, and particularly those with NO desire to learn about markets, I’m much more in favour of this type of investing than conventional advisors. I think they’ll gradually put financial advisors out of business, or at least cut their fees substantially.