Market volatility could benefit robo-advisers

By johnjames ·
May 27 2016

Market volatility could benefit robo-advisers

The pessimistic view is that robo-advice will fail to thrive as investors back away from digital and algorithmic investing, and put their trust in the hands of advisers.

This argument is too simplistic in that it discredits the role that advisers play in delivering robo-advice and also assumes a greater level of trust in humans vs machines.

While this may largely be the case, there are some segments of the market - millennials in particular - more likely to put their confidence in a technology-based solution.

More important is the fact that robo-advice can actually help both advisers and investors when it comes to managing volatility.

Removing bias and managing risk

True robo-advice platforms use highly sophisticated algorithms to construct and manage goal-based portfolios.

These are not model portfolios, but rather globally diversified portfolios tailored to an investor's individual goals and risk appetite.

The more sophisticated algorithms also consider factors such as cost, liquidity, turnover and tax efficiency.

Of course, professional advisers have done this independently of robo-advice for years, but now they have the technology to do it more efficiently and without bias.

This removal of behavioural bias is key to managing risk and is one area where machines will always have an advantage over humans.

One of the biases robo can help advisers and investors avoid is the so-calledhome bias where investors favour assets within their own market.

This bias can limit diversification and, in a volatile environment, completely exposing an investor to just one market may not be the optimal way to meet their goal.

Robo-advice can further manage risk by automatically rebalancing portfolios on a daily basis and ensuring investors maintain an allocation within their risk profile.

A natural extension to rebalancing is the automated tax loss harvesting that robo-advisers can provide.

By searching the portfolios for harvesting opportunities daily, the investor has the opportunity to gain additional tax alpha by writing down losses more frequently, and at the same time reinvesting in highly correlated assets to maintain the allocation they have chosen.

Optimising alpha generation

While neither an algorithm nor a human can construct a portfolio that's immune to market turbulence, if the platform has investors simply tracking a market index, then the portfolio is not going to be optimised for the current market or the investor.

True robo-advice platforms construct globally diversified portfolios that create alpha in the most optimal way for each investor.

Many of these platforms have turned to low-cost, tax efficient and highly liquid ETFs to generate alpha, focusing on funds which have the highest risk-adjusted expected investor returns.

Some use active management to add additional alpha to a portfolio over the long-term.

Some platforms also use data based on the global market's collective view to generate forward-looking return estimates and model for worst case scenarios.

This allows for further optimisation and hedging against downside risk.

These capabilities help advisers and investors create maximum alpha without chasing fund manager returns or relying on one's ability to pick a 'winner'.

Also, the high levels of automation offered by robo-advice helps reduce overall fund management and transaction costs.

With these benefits and many others, it's clear robo-advice is not just a trade-off between advisers and technology.

It's about giving advisers and institutions a platform to deliver sophisticated and tailored advice more efficiently.

In a bearish market where lower returns may have investors focused on cost and risk/return, this is more critical than ever.

John James is the founder and chief executive of robo-advice company BetaSmartz.

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Market volatility could benefit robo-advisers

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