The pros and cons of robo-advice: Miss Mackay's Money Microscope
Robots can now do pretty much everything from clean the house to fix the car. There are even social robots who can provide companionship in the long winter evenings; but can they give investment advice? More to the point, should investors let them?
Robo-advice has been heralded as the 'next big thing' in investment management. We estimate that circa £140 million is managed this way in the UK, with nearer $50 billion (£35 billion) in the US. A report from management consultancy group Deloitte notes that the US is seeing impressive growth rates of 65 per cent plus.
These robo-advisers are seen as the solution for those investors who are not inclined to pay for specialist advice from a wealth management firm, but might be willing to pay a lower fee for an automated online service, possibly with telephone support.
In this, robo-advisers aim to ape the popularity of banking groups such as First Direct, which realised many people don't necessarily need a face-to-face service.
The premise is sound. Many people need some form of advice on where to put their money, but do not have the complexity or wealth to justify a full financial advice service. But it raises questions.
How far does the new service provide an adequate solution for this part of the market? Could people find something better elsewhere? And just what are the risks involved in using these new players?
The UK market is still small today, and Nutmeg has been the dominant player. Nevertheless, more are emerging, such as True Potential and new entrant MoneyFarm.
Scalable Capital is on the brink of launch - and has just raised a further £5.6 million for its war chest - and there are lots of 'advice-lite' models being brought out by adviser firms to help smaller clients, many of them powered by a bit of kit called Parmenion (which in turn is owned by Aberdeen Asset Management).
The approaches are different, depending on the group. For example, MoneyFarm, which has already launched in Italy and built a significant presence there, is regulated to give advice in the UK, and there is an element of advice hardwired into the investment selection process.
This takes the form of a risk questionnaire, which asks about an individual's existing finances, financial goals and ambitions, but also assesses 'softer' elements, such as the client's emotional response to risk.
It is difficult to override the system, and therefore there is little risk of picking a pool of investments that don't fit with the answers. The output from the questionnaire leads to one of eight portfolios, invested exclusively in exchange traded funds (ETFs).
The group has an investment team that decides the right blend of equities, bonds and 'other' investments for each risk profile and for the prevailing investment climate. These are reviewed and adjusted over time.
Scalable Capital, in contrast, does not believe its role to be giving advice. It builds tax-efficient portfolios and adopts an investment methodology called 'volatility clustering'.
This could be loosely described as managing money with the core belief that 'when it goes wrong, it tends to go horribly wrong', and when it's going up, there tends to be a nice long sunny spell - and tweaking the holdings accordingly. This is all algorithm stuff and human intervention is minimal.
The issue with all the robo-advice models is that they are effecively cookie-cutters and the results will only be as good as the shape of the cookies they've been programmed to make.
The model is being adopted by the high street banks, and there is the risk that they, in turn, will stuff their portfolios full of low-quality in-house products. Nationwide and RBS are two names launching services later this year.
To my mind, the biggest problem with a purely 'robotic' approach is that there is a certain amount of systemic risk. If one biscuit is burned, the whole batch will be.
All models are, to some extent, backward-looking, and incorporate assumptions based on how asset classes have performed historically. The stock market has delivered around 5 per cent over the very long term, and it is assumed that it will therefore do so again in future.
But, clearly, the environment changes. Many hedge fund algorithms were wrong-footed by the extraordinary monetary policy adopted by the central banks in the wake of the financial crisis.
There is a chance that this could happen again. Without human input, investors do not have much protection.
WHICH OPTION IS BEST?
Ultimately, it is for investors to decide whether they prefer the model of the 1990s, where ex-insurance salesmen picked portfolios based on who they had played golf with, or the model of the future - clever algorithms which are still ultimately programmed by flawed humans who may also play golf.
Robo-advice is cheaper than discretionary management, and in many cases investors are getting a similar service. Some discretionary managers are not quite as 'discretionary' as the name implies and themselves make widespread use of automation and model portfolios.
However, investors still need to be careful on costs. Many of the quoted 'all-in' charges do not include the cost of the underlying investments. ETFs aren't expensive, but will nevertheless add 0.25-0.5 per cent to the cost of the investment.
Investors also have to ask whether robo-advice is a better option than straightforward multi-manager funds, which are at the other end of the scale. Here too, investors have a portfolio selected for them, and have a variety of options in regard to risk.
Certainly, advice is not embedded, but many fund platforms have tools to help people determine their basic risk level. Costs on multi-manager funds have come down considerably, and for many are around 1-1.25 per cent.
In these funds, investors will have active asset allocation - as they get with robo offerings - but this may also include active funds, which offer a greater chance of outperformance if the manager's selection is good. Investors must decide which option floats their boat.
As with any new development, there may be charlatans (at worst) or naïve dreamers in the mix. This robo stuff is all very interesting and the private equity firms can't get enough of it, but it's embryonic and I think investors need to be really careful about where they put their money.
Some of the newer players can't accept debit cards to fund accounts, and cash has to be sent to unknown accounts by transfer. I've done this as part of my research, opening up accounts with many players, and I found it very unnerving.
Of course the robos know this isn't ideal, and many are working on it as a priority improvement. Nutmeg, the grand-daddy of UK robos, offers a notably more reassuring experience than most.
These experiences also raise data protection and security issues. Investors should ensure that the company has a proper custodian, who is holding their money and keeping it safe.
COMPARING APPLES WITH PEARS
One problem with robo-advice versus other options is that it is new and therefore it doesn't have much of a track record. Established players such as Nutmeg may be able to show investors what they have achieved over time, but with others it may be more of a shot in the dark.
At Boring Money, we are currently working with the robo players to try and quantify some comparable investment performance history. It's no easy task.
Do we factor in experience in different markets? Can experience with Italian bonds be seen as relevant to competence managing UK bonds?
What if track records are less than a year? How do we do this net of fees? Do we accept simulated models of 'how we would have performed had the system been live'?
Although the hype tends to be on the digital aspects of these disrupters, at the end of the day they are managing our money and we actually want to focus on performance net of fees.
And it's proving tricky. This is a new part of the market. As such, the good has not yet been sifted from the bad.
But in some cases robo-advisers may be able to achieve much the same thing as current discretionary services in a far simpler way.
Robo-advice is likely to take market share; it is certainly acting as a catalyst for good in the ongoing war against pricey fund managers, and for some investors it will prove a blessing because of the simplicity, serving up an investment 'ready meal' to people on the go.
Robo-advice could significantly impact the investment management industry, but it comes with risks of mis-selling, algorithmic flaws and data privacy issues, says a new CFA Institute report.
The research, conducted with the well-qualified and mathematically able Chartered Financial Analyst group members, found that:
- 47 per cent had concerns about service levels;
- 46 per cent had concerns about flaws in the algorithms used by automated advice propositions;
- 30 per cent were concerned about fraud;
- 12 per cent thought there could be a potential 'mis-selling' issue.
However, investment professionals are clear that the growth of robo-advice will have a positive impact on the costs, products and availability of advice for 'mass affluent' consumers.
Holly Mackay is founder and managing director of Boring Money.