Would You Trust Your Nest Egg to a Robot?
A fairly spectacular battle just took place in the asset-management world. The fight was between Adam Nash, chief executive officer of Wealthfront, and Charles Schwab Corp. Wealthfront is an automated investor service, or robo-adviser -- a type of service that has soared to prominence in the last few years. Schwab, an old-line discount brokerage, is rolling out its own robo-adviser service. This battle is extremely interesting, because it demonstrates that the money-management industry is moving relentlessly toward more automation, while illustrating some of the fundamental difficulties of differentiating oneself in the new passive-management world.
The crux of the dispute is Nash’s allegation that Schwab’s robo-adviser is a bad deal for investors. Nash noted that Schwab’s service will keep a significant amount of its clients’ holdings in cash, rather than in more risky investments. Since return and risk are correlated, that will reduce the average returns of the portfolios Schwab’s robot manages, while also making those portfolios safer. Nash also ripped Schwab for using smart beta exchange-traded funds in its robo-adviser portfolios. Smart beta funds are mostly passive funds that use small allocation tricks -- such as equally weighted instead of capitalization-weighted portfolios -- to get slight outperformance. Nash claimed that smart beta isn't a good idea. He also argued that Schwab’s fees are too large.
Schwab, of course, fired back. It pointed out that most investors are risk-averse to the point where they want to keep some of their assets in cash. It also defended the use of smart-beta funds and argued that Wealthfront charges more up-front fees than Schwab.
I don’t want to step into this dispute -- suffice it to say that both sides have strong arguments, and that disputes over cash allocation, smart beta and fees are common throughout the financial industry. Instead, I want to talk about two things that the argument shows about the direction of the industry.
First, the fact that companies are fighting so openly over the robo-adviser market underscores how big and important this market might become. Wealthfront, the biggest robo-adviser, already manages more than $2 billion -- a small amount compared to traditional asset managers, but up 10-fold in the past two years or so. Betterment, a competing robo-adviser, is hot on its heels. And the fact that big companies such as Schwab are rolling out their own services means that this business model is expected to be important.
The whole financial world, essentially, is turning against active management -- where a fund manager picks specific securities or tries to time the market. This is probably being driven by several trends -- the rise of ETFs, the poor average performance of active managers after fees and the end of the high interest rates that might have concealed underperformance in the past. Essentially, the theories of economists such as the University of Chicago's Eugene Fama and investors like Vanguard founder John Bogle are winning out.
But the big question remains: What will replace active management? What form will the new passive world take?
Robo-advisers are one answer. They basically combine simple asset allocation formulas with slick user interfaces on the Web to encourage people to put in their money and leave it there. The algorithms are mostly so simple that a finance doctoral student could implement one in less than a day of coding. That, after all, is the key to passive management.
The real value proposition of robo-advisers is behavioral. Investors are subject to an array of biases, including the temptation to chase returns and to try to time the market. Robo-advisers, with their fancy user interfaces and user experiences, hope to be able to cancel out these biases.
If you think about it, this must be the value-add of robo-advisers. After all, just buying a few ETFs and index funds on ScottTrade, and then forgetting about them for 20 years, will generally give you just as good a return as what the robo-advisers are offering, for slightly lower fees. Index funds basically are robo-advisers without the front-end. Robo-advisers add value if -- and only if -- investors find it much easier to give their money to a robo-adviser than to do the procedure I just described. That’s why robo-advisers are, fundamentally, applied behavioral finance technologies.
The problem is, behavioral bias correction is a hard sell. Most people don’t realize their biases exist. In the finance industry, investors are used to thinking not in terms of behavioral correction, but in terms of outperformance. We are conditioned to think that better money managers get us higher returns. In a recent report, State Street’s Center for Applied Research called this conditioning the “folklore of finance.” Essentially, investors have been trained to hunt -- fruitlessly -- for managers who can give us market-beating alpha instead of thinking carefully about how to implement investing goals and risk preferences.
That means that robo-advisers are in a bit of a bind. They find themselves in the same position as human advisers -- of offering a passive product, but facing a clientele that expects alpha. That will inevitably lead them to tweak their models to have a sheen of activeness -- to use smart beta, differing cash allocations and differences in fees to try to convince customers that they have a tiny bit of alpha. I heavily suspect that the pressure of the folklore of finance is what is really behind the Nash-Schwab dispute.
But the truth is, the alpha available to robo-advisers is so tiny that in the long term there is absolutely no way for them to distinguish themselves this way. Let's hope the folklore of finance will slowly vanish, and investors will become ever-more comfortable with earning average returns. But if that happens, robo-advisers have to ask themselves if investors become totally comfortable with passive investing, will they just bypass the robo-advisers and just buy some Vanguard ETFs? It is on the answer to this question, I think, that the future of the industry hinges.
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