How to mitigate the risks of Robo advisors
A young affluent couple in their mid-twenties has cash to invest. These millennials are mistrusting of the traditional options available via the big banks and have been exposed to some pretty convincing marketing material from the alternative, a fintech offering robo advisor services. They are confident of the outcomes – it’s low cost and long term – so sign up for their robo portfolio. The portfolio looks good. Its distribution is 80/20, there are automatic periodic deposits, a broad spread of ETFs and risk has been considerably reduced by anticipating the couple’s lifecycle.
What could possibly go wrong?
The rise of the robo advisor
Using a robo advisor to automate the asset allocation of investments via a computer algorithm is big business that is rapidly gaining ground. It's set to disrupt the global wealth management industry. Business Insider UK forecasts that robo advisors will manage around 10% of total global assets under management (AUM) by 2020 – that’s about $8 trillion.
It’s certainly true that due to automation, fees are considerably lower but can robo advisors ever really offer the same type of service as a human? This article explores some of the risks of using robo advisors and how to mitigate them.
Check out the back office
Understanding the whole investment philosophy of a robo advisor is important, but their back office is equally crucial to clock if our young couple are to really mitigate their risks.
Important questions to ask include: Do you understand where your assets are held? Is it possible to reach someone on the phone or by email? More critically, if something happens in your life that changes your finances, how quick and easy is it to amend your risk profile with the robo advisor?
Knowing these things will give our millennial couple peace of mind and a clear idea of what to do, should things change in their lives.
What to do in times of market volatility
Our millennial couple have never lived their adult lives through a financial crisis – not the flash crisis 2010, credit crisis 2008, 1987, 1929…. It’s certainly something that robo advisors can’t easily handle or advise on. But left to their own devices robo advisors will do their job. Over the years, we’ve learned that the markets nearly always restore themselves but our emotional reaction to a crisis is to buy high and sell low.
For our couple, and others like them, market volatility typical of a crisis situation, combined with no experience of such a scenario and little or no human advice could trigger a chain reaction of panic. One person sells, then 1000 people sell, then 1m sell – suddenly there’s a complete meltdown. What happens to algorithms, the market and liquidity?
In the face of potential crisis how can our young couple reduce volatility and increase confidence in their portfolio?
Use of structured products to reduce portfolio volatility
Portfolio volatility can be reduced by bringing structured products into the equation. Spreading the risk has a net effect of keeping investors with their robo advisors and decreasing the likelihood of them jumping ship at the first sign of crisis.
Different robots work in different ways, but they all have one thing in common. They are based on software which automatically allocates your equity over different asset classes with as little intervention from people as possible. Basically, the main thing they do, is rebalance your application to a pre-defined asset allocation. And if you’re lucky, your robot also takes in to account your lifecycle. Maybe it would be even better to call them robot allocators instead of robo advisors.
With smart software and algorithms, which should be smarter and produce a better result for the investor, the idea is to use structured products alongside traditional products to reduce risk whilst enjoying all the benefits of using a robo advisor.
These products come in different types and can be a strong replacement or addition to the core portfolio of the robo advisors. Examples of Structured Products include; Barrier reverse convertibles, Participation Products, Leverage Products and Capital Protection / guaranteed. Given our caveat emptor warnings above, this capital guarantee seems to be a first pleasant addition to the assets of the robo advisors.
Structured Products with capital protection / guaranteed
Structured Products with capital protection / guaranteed have three major benefits:
- Defined returns
- Market protection barriers
- Known maturity dates
In combination, these decrease the risk and increase the expectations of the core portfolio towards a direct investment in traditional products.
Besides that there is a variation of these products. For example, a 100% protection of the inlay with a cap on the return, 95% protection without cap, a 75% protection with a participation of 125%. Enough to tinker with for the robots. Of course, there are also cons on these products like not sharing in dividend. Something for Personal Capital, Betterment, Wealthfront, WiseBanyan, FutureAdvisor or Charles Schwab?
Other Structured Products
Of course other kinds of Structured Products can be interesting. For example think of barrier reverse convertibles with interest products, Participation Products and Leverage Products to give an allocation at a young age.
Can Structured Products be used to mitigate risk? To comfort the investors so that they won’t dump their portfolio? So they can sleep well and have trust in the long term?
Honestly – it’s difficult to judge and to decide whether we can apply ancient wisdoms to new situations.
However, the survey by Lowes (2015 Structured Products Annual Performance Review Lowes performance review report) already shows that structured products give a better result opposite benchmarks such as the FTSE 100 with an ever lower risk.
According to the data; from the 424 products which ended in 2015, 416 ended with a positive result. Therefore, my advice to our millennial couple would be do their homework and include structured products alongside their robo portfolio. (And by the way I am not a robot!)