Find out if you should go robo

There’s a new way of managing your money that’s beginning to shake up the investment world. Online portfolio managers—better known as “robo-advisors”—are designed for today’s digital world and provide you with a professionally managed portfolio at low cost even if you have only a small amount to invest.

The impact of this wave of robo upstarts on wealth management has been immediate. The big banks and other major players are taking notice, even if only for the automation and ease of paperless account administration and portfolio rebalancing. The bigger and longer-term questions are how much market share the robos will ultimately be able to win and how the disruption could force the traditional advisor community to raise its game.

While at this point robo-advisors in Canada have yet to accumulate a lot in assets, at least 11 firms have launched in the past two years, including Wealthsimple, Nest Wealth and the Bank of Montreal’s SmartFolio. It’s safe to assume the big banks and discount brokers won’t roll over to the new kids in town. At this point, the one thing that is clear is that the investing business is in for some changes. It’s time for investors to take a closer look.

“The impact of this is going to be dramatic for sure,” says Mark Yamada, president of investment software firm PUR Investing Inc.

A 19-year-old reviews robo-advisors »

Simple not simplistic

What robo-advisors do is simple yet profound. They automate parts of the investment process to build and maintain diversified portfolios using exchange-traded funds (ETFs) with low fees. Even better, you can do it without any paperwork, from the comfort of your couch or, more likely, from your smartphone when you’re run off your feet with career demands. However, the adopted name for these new services is misleading because robo-advisors also provide access to qualified human advisors when needed. (Providers hate the term “robo-advisor,” but it has nonetheless stuck.) Robo-advisors can save roughly one percentage point in fees for small- and medium-sized investors, compared to the total fees charged for a conventional full service advisor using mutual funds. This is an enormous savings when continuously accumulated and compounded long term.

Generally, robos provide a set number of soundly constructed portfolios composed of ETFs that are automatically matched to each investor’s needs, based on an online questionnaire which determines the investor’s risk tolerance and objectives. Each portfolio is subsequently rebalanced automatically as needed whenever actual balances diverge significantly from their target allocations.

Usually everything is paperless, right down to you providing an electronic signature in the sign-up process. You can access your account any time you want online and, in many cases, also view your account via smartphone or tablet using an app configured for those devices. Small investors are welcomed—in some cases account minimums are $5,000, in other cases there is no minimum. Meanwhile, qualified human advisors are available by chat, email or phone to answer questions and provide advice on basic investment questions as needed.

While these features can appeal to any age group, the approach obviously fits many younger investors like a glove. “It’s going to open people’s eyes and it happens at a time when the generations are changing very quickly,” says Yamada. “Generation Y is not in all likelihood going to invest the way their parents and grandparents did.”

At this point, the robo-advisor customer base in Canada is still tiny. Independent startup Wealthsimple, one of the first firms in Canada to launch and the only one so far to disclose numbers, says it had 10,000 clients and $400 million in assets under management as of December, 2015. But those figures could grow quickly, as has been shown by the U.S. experience, where pioneers Betterment and Wealthfront each have more than US$3 billion in assets. Businesses are keen to get in on the ground floor, with several new players due to come to market to join the 11 services already launched. Behind the scenes, many are discussing deals and partnerships. Already, Power Financial Corporation has announced an investment of up to $30 million in Wealthsimple.

But perhaps the biggest splash so far has been the heavily marketed introduction of the Bank of Montreal’s SmartFolio service in January, the culmination of a seven-month project. “In bank terms, that’s warp speed,” jokes David LeRiche, director of wealth strategy at BMO Wealth Management. “Getting to this space quickly and getting there first (among the big Canadian banks) was important to us,” says LeRiche. “There is an opportunity to establish ourselves as a big brand in this innovative space.” Expect other banks and financial institutions to follow. As Yamada says: “Once the banks enter the space, it validates it.”

Low-cost mutual funds or robo-advisor? »

Which robo-advisor is right for you?

Filling a gap

Robo-advisors serve what Randy Cass, CEO of Nest Wealth, which is rolling out a national robo-advisor service, calls the “forgotten middle.” That’s the gap in the marketplace between do-it-yourselfers (who can invest very cheaply at a self-directed brokerage but need to contribute time, effort and knowledge to do it well), and conventional full service advisors (who may provide ample advice, but typically charge around 2% in total fees to build portfolios out of mutual funds). Larger investors can tap other options like brokers or investment counsellors who may provide quality advice more cheaply, but you need at least several hundred thousand dollars and probably more to get that kind of advice for much under 2% in total fees.

In contrast, robo-advisors provide an opportunity for investors who don’t want to do it all themselves but like the fact they can save surprisingly large amounts in fees. While fee structures vary among robo-advisors, many of their investors pay total fees under 1%, even if they only have a few thousand to invest. (These “total fees” include amounts charged by the robo-advisor as well as the management expenses embedded in the ETFs they use. Note that some robo-advisors charge quite a bit more on small balances.)

Of course, investors who have the time, inclination and knowledge to invest in ETFs effectively on their own can save even more in fees by doing it themselves.

Beyond their simplicity, the key idea behind the robo-advisor model is that it automates parts of the process that enable it to achieve efficiencies, while retaining human involvement where that provides value. If an investment firm has thousands of clients with similar objectives and risk tolerances, there’s no particular need for different advisors of varying qualifications to construct and maintain thousands of unique portfolios for individual clients (which of course costs money and produces results of varying quality). Instead a robo-advisor gets the best investment brains in the organization to construct set portfolios, as with different models of cars, that can be matched to different groups of people with similar risk tolerance and objectives. “If it works in the auto industry why can’t it work elsewhere?” asks Yamada.

Robo-advisors typically follow sound investment practices to build well-diversified portfolios covering all the main asset categories. Each robo-advisor generally has five to 10 standard portfolios composed of ETFs that vary mainly by the amount of market risk that they carry, covering a spectrum from very conservative to very aggressive. Each set portfolio usually includes core asset categories that include investment-grade bonds, stocks (Canadian, U.S. and global) and sometimes also other asset categories such as real estate investment trusts, emerging markets equities and high-yield bonds. These portfolios can be held in non-registered accounts, TFSAs, RRSPs, RRIFs and often in more specialized accounts like Registered Education Savings Plans (RESPs). Of course, once you agree that the robo-advisor has matched your profile with a suitable portfolio, you need to turn over the day-to-day management of the portfolio to it. Robo-advisors are usually registered as portfolio managers and are responsible for managing your money to a “fiduciary” standard (which means they’re obligated to do so in your best interests). That’s higher than the “suitability” standard (which means they can’t sell you unsuitable investments) that governs most advisors.

“I’m so much more than a robo-advisor” »

Passive vs. active

Robo-advisors mainly follow in the “passive” investing tradition, which means that you’re generally using ETFs to track the market at low cost. Some follow the classic passive approach which uses ETFs that track broad-based market indices based on market capitalization. The classic passive approach also avoids trying to “time the market” by adjusting the asset mix according to market conditions. Others follow more of a hybrid approach that mixes active features with passive ones to varying degrees. This includes using “smart beta” ETFs that may, for example, be designed to have low volatility, instead of following a broad market index weighted by market capitalization. Some may also adjust the asset mix according to market conditions, doing things like boosting the equity component when they think stock prices are relatively attractive.

Passive investing experts have long constructed model portfolios to guide do-it-yourself investors in constructing portfolios. (These include the “Couch Potato” portfolio by financial advisor and MoneySense contributing editor Dan Bortolotti, and the “Easy Chair” portfolio by finance professor Eric Kirzner.) Robo-advisors take this one step further by doing everything for you. “It’s a logical development of everything I ever talked about,” says Kirzner, professor of finance at University of Toronto’s Rotman School of Management and an advisor to Wealthsimple. “You’re buying a sophisticated version of the Easy Chair.”

Fits a digital world

While robo-advisors are going after clients in all age groups, it has obvious appeal to younger investors who thrive on digital media. These investors have no ingrained history with conventional advisors who are mostly from their parents’ generation, and, at this point, have relatively small balances that conventional advisors may neglect.

“We’re pretty explicitly focused on young professional investors,” says Wealthsimple CEO Mike Katchen, who is 28. “The sweet spot for us is 25 to 45 years old.” The typical characteristics of the target client, he explains, is they have income to invest, are aware they should be putting their money to work in a smart way and don’t have the time or interest to figure out how to do that themselves. “These folks are often very career-driven and time is often what they are most constrained by. So they’d much rather just outsource it to someone they trust to do a really smart job at a low cost. That to us is the core client.”

Robo-advisors won’t make conventional advisors obsolete. But it will be much harder for conventional advisors to justify their relatively higher fees if all they do is build and rebalance portfolios. “For a bunch of advisors out there who have been living a very nice life collecting very high fees, doing exactly the same thing a robo-advisor is now doing at a lower fee, they’re going to have to repurpose and add more value,” says Yamada. Advisors can potentially do this by focusing more on activities like financial planning, tax planning and behavioural investment counselling. And you’ll still need a conventional advisor if you want to be heavily involved in the day-to-day decisions of running your portfolio but want expert advice.

While robo-advisors may provide a threat to conventional advisors, they also offer an opportunity. Plenty of discussions are going on about how conventional advisors might incorporate the robo-advisor platform in their own practices so that they can focus more on activities that add value. Nest Wealth’s Cass has a message for conventional advisors: “We come in peace.” Robo-advisor platforms may also find use in employer group RRSPs and defined contribution pension plans. Employees in those plans often make poor investment choices, but employers have traditionally been loath to pay for costly advice from conventional advisors. Nest Wealth and Wealthsimple both have plans to tackle this segment.

For now, conventional advisors are likely to better satisfy the needs of many older investors. Often this group has more complex investment and financial planning needs (which benefit from more intensive and sophisticated advice) and larger balances (which make conventional advice more cost-effective). But that doesn’t mean robo-advisors can’t compete in this segment. Already one robo-advisor, WealthBar, can create a full financial plan online that includes a retirement withdrawal plan and coordinates that with its portfolio design and investment approach. “We can handle most of the simple basic plans,” says Tea Nicola, WealthBar’s CEO.

Should I use a robo-advisor? »