Q1 2018 Robo Report: How Market Volatility Affected Robo Services
Posted on June 14, 2018
Included in The Robo Report’s quarterly report on the digital advice industry is performance data on real accounts opened by BackEnd Benchmarking. Providing performance data allows for comparison across different digital advice platforms and helps investors make informed decisions when selecting a robo-advice product.
For comparability across portfolios, a similar investor profile is set up with each robo upon opening an account and a portfolio allocation of close to 60% equities and 40% fixed income is sought in the taxable portfolios.
To help readers understand portfolios that have different target allocations, we track the equity-only and fixed-income only portions of the portfolios and encourage investors to look at differences in target allocations and compare asset classes when appropriate. As for the IRAs, our goal is to have the most aggressive (highest stock) allocation.
New Portfolios and Products
For the first quarter of 2018, we introduced three socially responsible investing (SRI) portfolios to the report from robo-adviser services at TIAA, Betterment and Morgan Stanley. Additionally, we are publishing the results for the first time from Morgan Stanley, Wells Fargo, USAA, United Income and Capital One. Next month we will be introducing SRI portfolios from WealthSimple and Hedgeable.
UBS launched its robo-adviser—UBS Advice Advantage—during the first quarter. It has a $10,000 minimum and costs 0.75%, which is higher than some of the competitors. Surprisingly, the consumer goods retailer Overstock.com also announced a robo-adviser offering during the first quarter. The move was widely criticized, but the Overstock.com CEO pushed back, pointing out that the website currently has 40 million unique visitors per month and existing financial product offerings, such as loans.
We expect robo offerings from JPMorgan Chase & Co. and Goldman Sachs later this year.
Also notable this quarter was a new product from Wealthfront. The company announced a new proprietary risk/parity mutual fund that drew a variety of criticisms. The newly released fund employs a risk/parity strategy that is supposed to increase risk-adjusted returns and will be included with an allocation as high as 20% in eligible accounts that do not opt out. Some in the investment community are pointing out that by offering a proprietary mutual fund, Wealthfront is introducing the common conflict of interest of selling one’s own products. The mutual fund employs a complex strategy that comes with a higher expense ratio and will increase fees paid by investors and, in turn, increase the amount earned by Wealthfront. Robo offerings from companies that had existing exchange-traded fund (ETF) and mutual fund businesses, like Vanguard or Schwab, typically use most or all of their own funds in their portfolios, but this is the first time we have seen the creation of a fund from one of the major independent robos.
This product employs a relatively complex strategy that uses leverage, either through direct borrowing or derivatives like futures or swaps. This fund represents a departure from Wealthfront’s low-cost passive indexing strategies. Our opinion is that the introduction of leverage to a portfolio is something that clients should clearly understand and actively consent to.
Another concern raised is that the expense ratio underestimates costs, as this fund’s expense ratio does not include the cost of swaps used in the strategy, which can be significant. The expense ratio was originally set at 0.50% but was halved to 0.25% in mid-April.
Volatility During the First Quarter
Volatility returned to the markets in the first quarter of 2018. As represented by the S&P 500 index, the U.S. stock market had six days of moves that were either higher or lower by 2% or more in the quarter, after no such moves in the entirety of 2017. Even the most tenured robo-advice products have come of age during historically low-volatility markets. This quarter was one of the first glimpses of how robo-advice products performed through increased volatility.
In the turbulent first week of February, volatility created other issues for Wealthfront and Betterment. The large downward movement of the market on February 5 created spikes in traffic across financial institutions’ websites. Wealthfront and Betterment experienced outages on their websites that prevented clients from logging on to view or take action on their accounts for brief windows during the day. However, while these outages made headlines at the time, they were not the only financial institutions that had online traffic-related issues: Finance heavyweights Fidelity, Schwab, Vanguard, T. Rowe Price and TD Ameritrade all reportedly had issues with website response times or accessibility. Although the websites’ outages and loss of access for investors are not trivial, investors should not rush to conclusions about Wealthfront and Betterment from this incident.
One of the largest misconceptions about robo-advice products is that they are driven by complex trading algorithms in an attempt to beat the market. Although there are some products out there that employ active trading strategies, they are in the minority. In reality, most robo-advice portfolios are passive, long-term and infrequently traded portfolios.
During the swings seen in the first quarter, a vast majority of our robo portfolios did not experience large amounts of trades. These portfolios are typically designed for long-term investing and most do not trade on short-term market movements. The taxable portfolios we track are opened with as close to a 60/40 equity-to-bond mix as possible, and their performance was in line with what would be expected of a passive, globally diversified, 60/40 account. The automated trading done in robo-advice products usually centers around rebalancing and tax-loss harvesting, and it was not surprising that we saw very few trades in response to the tumultuous markets.
However, one of the advantages to the automated trading systems that are behind robo-advice platforms is their ability to trade when the systems detect opportunities to harvest tax losses. Large swings in asset prices can create more opportunities where assets are priced below the purchase price.
For those who do not know, tax-loss harvesting is the strategy of selling investments with unrealized losses. The sale is typically paired with the purchase of a very similar asset so as not to change the overall allocation and strategy of the portfolio. These losses can then be used to reduce taxes for the year, increasing the aftertax returns of the portfolio. Accounts that have been funded recently, or have regular contributions, are more likely to see opportunities for tax-loss harvesting.
First-Quarter 2018 Robo Performance
Aside from heightened volatility during the quarter, quarterly performance was dragged down by concerns over valuation, Federal Reserve rate increases, trade war and inflation concerns. The S&P 500 ended the quarter down 0.76%. Internationally, results were mixed, with developed markets finishing the quarter down and emerging markets posting a small gain. While the technology sector was once again the top-performing sector, it was not immune to the market’s newfound volatility. Most other sectors posted negative returns, with energy, consumer staples and telecom among the biggest laggards. Growth slightly outperformed value, and small caps edged out their mid- and large-cap peers by a small margin. Additionally, real estate performed poorly on concerns that rising interest rates would slow demand.
Fixed-income markets faced a variety of headwinds, ranging from the Federal Reserve’s slow increase in rates, rising yields abroad, concerns over the return of inflation and a ballooning national debt. Fixed-income portfolios with a more risk-on approach have fared well in both the short and long run. In a persistent low-yield environment, investors continue to seek income from high-yield bonds, which have shown resilience in a diffcult quarter. Expanding abroad has paid off in many cases, as some of the best-performing fixed-income portfolios are those holding international debt.
Although performance was in line with what would be expected of a mostly passive portfolio during the first quarter, it does not mean that all portfolios are created equal. Some trends emerged when analyzing the results of our portfolio this quarter. Some of the largest dispersion of returns we saw were in the fixed-income section of our portfolios.
We also saw some of the largest differences in types of fixed income used. Portfolios that ventured into riskier areas of the market were rewarded over both the shorter and longer term. In particular, Schwab stands out in regard to fixed-income allocation. Their holdings in high-yield bonds and international fixed income helped spur their outperformance. Ellevest and Personal Capital also outperformed in fixed income, with allocations to high-yield municipals and high-yield corporate bond ETFs, respectively, as well as the same emerging markets bond ETF as Schwab. FutureAdvisor also benefited from sizable positions in an international bond fund, as well as a TIPS ETF positioned at the shorter end of the yield curve.
Portfolios with higher-than-average emerging markets and small-cap exposure tended to fare better. Both SigFig and SoFi have some of the highest dedicated allocations to emerging markets, helping them both secure a spot on the quarter’s leaderboard. United Income employs a focus on small-cap equities as one of their actively managed strategies, which benefited them this quarter. On the other hand, Personal Capital lagged, with their sector allocations to energy, consumer staples, telecom and real estate creating drag. Betterment’s value tilt also held back equity returns in the first quarter.
Our results imply that investors should look for diversification not only in the equity holdings, but also in fixed-income holdings.
Figure 1 shows the top-performing robo portfolios during the first quarter of 2018, as well as the last year and last two-year periods. Figure 2 shows robo-adviser performance for taxable accounts. For information on IRA account returns and account facts, see the Robo Report.
Conclusion
As the digital advice market continues to mature, we are seeing an increase in features and portfolio types in robo-advice products. Last quarter, Betterment introduced a more flexible portfolio. Those investors who would like more control over the construction of their individual portfolio can now do so with Betterment’s new Flexible Portfolio feature, which allows for adjusting individual asset class weights. Morgan Stanley recently launched a digital advice product that has a wide selection of portfolio types. Those who like the idea of pursuing a specific thematic tilt to their portfolio should consider looking at the options provided by Morgan Stanley. Morgan Stanley is not the only one providing portfolio options, as quite a few platforms now offer socially responsible investment themes, also known as impact investing. For those interested in socially responsible investing, robos such as TIAA, Betterment, Ellevest, Morgan Stanley, Hedgeable and WealthSimple now all have options for impact portfolios.
The first quarter of this year was another strong quarter for digital advice, as these platforms continue to be attractive and provide a good entry point for many investors to professional advice. The Robo Report looks forward to continuing our coverage of the industry and providing transparency to investors interested in digital advice products.
Tagged News, Performance, Wealthfront
