Robo advisors: What’s behind the curtain?

Your sister met her husband through an online dating site, your buddy let artificial intelligence choose chill music for his dinner party, and you’ve been known to buy camping equipment targeted at you through social media.

So how about letting a robo advisor manage your portfolio?

If you’re considering taking the robo route, read on – we’re taking you behind the curtain.

What is a robo advisor?

To begin with, so-called “robo advisors” are neither robots nor advisors. A better, but less catchy, term is automated investment manager. These have been around for about 10 years, although only about half that long in Canada, where they were a bit slower to catch on.

Even now, only 23 per cent of Canadian investors are aware of robo advisors, and 18 per cent of those have ever used one, according to the 2018 Canadian Mutual Fund Investor Survey by the Investment Funds Institute of Canada,

The benefits of robo advisors – offered by companies like Wealthsimple, Nest Wealth or BMO’s SmartFolio – include low fees and index investing that take emotion out of the equation.

Robo advisors use algorithms, or instructions describing how to perform a task, to buy and sell appropriate investments for individuals based on information those individuals have fed into their computers. They can’t think for themselves, but they can be programed to ask investors certain questions and take actions based on the answers.

They also don’t do much advising. Some of the platforms arrange an initial phone call between an investor and a human being who acts as a type of gatekeeper. Some have representatives on hand who can answer investors’ questions when they crop up.

Robo advisors can also send you emails or messages based on your preferences, what you’re invested in and what time of year it is (think: RRSP season and tax time).

But actual advice is limited, as is the number of people able to provide it, and that’s one of the main reasons their fees are so low.

How does a robo advisor work?

The algorithms used to determine which investments to buy and sell are designed by humans – typically quantitative analysts with deep financial backgrounds – and based on optimization programs that take into account the history of returns for different asset classes, like stocks and bonds.

“You go back a long period of time and you feed the information into an optimization program,” said Eric Kirzner, professor emeritus at the University of Toronto’s Rotman School of Management. Kirzner developed these types of algorithms for Schwab Canada years ago and has been part of Wealthsimple’s advisory committee.

“You put in some constraints, maybe limiting how much you can allocate to a certain class. And, if it’s a well-designed program and you’ve got very good data, then what should come out is a set of sample portfolios for different risk tolerances and different objectives.”

After their programs have determined what asset mix is best for which investors, other humans have to decide which specific products should be used in which types of portfolios to achieve the mandated asset mixes.

From there, it’s just “set it and forget it.” The software will automatically keep your portfolio balanced through market ups and downs.

Some programs will perform additional tasks, such as initiating trades to decrease your taxes, which is known as tax-loss harvesting.

Is a robo advisor right for you?

If you like keeping fees to a bare minimum and you don’t require much hand holding, a robo advisor might be for you.

Some investors might be wary about trusting the nameless, faceless people and programs behind these automated online investment platforms.

But it’s really no different from determining whether you can trust your human advisor and their supporting staff and technology, Kirzner said.

“There is some due diligence you may want to do as a potential investor, in terms of going to various websites and talking to some people who have used different platforms to give yourself some confidence that what you have is a well-designed, top-of-the-class type product,” Kirzner said.

“It’s the same thing that you would go through, the same selection process, if you were selecting a financial advisor.”

Finally, ask yourself how you would feel dealing with a robo advisor if your portfolio starts to tank.

Markets haven’t experienced a prolonged downturn since the advent of robo advisors, and no one is sure how investors will react when they do.

“I don’t know how investors who started out with robo advisors, and that’s been their only experience, are going to behave,” Kirzner said.

“You would hope that in a market period of extreme volatility the robo advisor firms would be sending out notes to their investors, providing some guidelines on how they should handle this.

But is it their job to call every investor and spend an hour talking to them? I don’t think so.”

3 months ago