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October 21, 2015 at 07:11 AM
As regular readers of this blog might remember, I’m not nearly as enamored as some about the introduction of so-called “robo-advisors,” nor as concerned about their potential “threat” to human advisors (see, for instance, Who’s Your Robo?). For one thing, in the robos I’ve looked at, the algorithms for choosing investments and managing client portfolios are so rudimentary that competitive long-term performance is unlikely, while the potential for taking a large hit to the robo portfolios’ value in the next market “correction” is quite high.
What’s more, I envision that in the near future, most independent advisory firms will offer improved robo portfolio options of their own, for smaller clients and those who prefer a lower-cost solution.
Yet my concern about robos is that investors—and everyone else—don’t yet understand the business they are really in.
I’ve been covering the financial services industry far too long to believe that they are truly giving away portfolio management “for free,” or for a few dollars a month. To provide some insight into what robos are really up to, I recently found a June 30 white paper called Robo-Advisors: A Closer Look, by securities attorney Melanie Fein.
In it, she reveals that the situation is way worse than I feared.
Fein explores multiple issues, including investment costs, outside revenue sources, the standard of client care and conflicts of interest. She concludes that robo-advisors “do not meet a high standard of care for fiduciary investing, and do not act in the clients’ best interest.”
It’s an analysis that every independent advisor should be familiar with—and not a bad idea to hand out to, or summarize for, clients.
As for credibility, Melanie Fein is no financial lightweight. Before opening her own firm, she was senior counsel to the Board of Governors of the Federal Reserve, taught at Yale law school and wrote the Bloomberg BNA “Overview of the Dodd-Frank Act.” In this paper, prepared for Federated Investors, her legal eye finds robo-advisors wanting in many areas, including these five key areas:
1. Data Collection
“The typical robo-advisor questionnaire allows investors to provide only limited information about their investment needs and risk tolerance,” she writes. “Critics argue that these questions elicit only superficial information that can result in no more than superficial asset allocation and investment recommendations.”
As you’ll see, this isn’t nearly the worst of it. Yet it does suggest that robos are still a long way from offering financial planning, which means that financial planner RIAs still have a very large advantage.
2. Outside Compensation
“While some robo-advisors may not charge a fee to users, they do not offer their services without compensation. The compensation they receive ultimately is paid for by their customers in the form of higher fees embedded in investment products and services. Robo-advisors receive compensation from affiliated and non-affiliated broker-dealers, custodians, and clearing firms that handle their customer’s securities transactions, and who similarly do not act without compensation. Robo-advisor users typically bear the cost of brokerage, transaction, and other transaction fees and expenses, whether directly or indirectly, and thus contribute to the robo-advisor’s compensation. Accordingly, it is misleading to say that robo-advisory services are “free” or even “low- cost” to the user.”
