In the earlier part of this series, I examined StashAway and AutoWealth and explained why Financial Horse would not use a robo-adviser in its current form. But Financial Horse is an investing enthusiast who spends every waking hour reading up on investment strategies and annual reports. I recognise that not everyone is this obsessive.
In this article, I will propose a simple DIY alternative that doesn’t require too extensive financial knowledge, or effort from the part of the investor.
Let’s imagine a hypothetical investor John. John is 25 years old. He has just graduated from NUS (with an engineering degree!), and earns a nice S$4,000 a month that he is very proud of. He wants to start investing, but he doesn’t really know much about financial markets or how to read a financial statement. He wants to park his money somewhere, make regular investments, and collect it in 30 years when he wants to retire. In fact, he is unconcerned with financial markets that he will only make new investments or sell securities on one trading day each year (his auspicious trading day). To minimise costs, he decides to open a Standard Chartered Trading Account, because the minimum commission is USD10, and there is no additional charge per quarter for US shares (John is really picky you see).
For John, I propose the following asset allocation, which I shall call the Financial Horse Alternative to Robo Advisers (FHARA):
As John is young, he can afford to have an outsized allocation to equities. The split will be 20% bonds and 80% equities, subdivided as follows:
|US Equities||NYSEARCA: VTI||50%|
|Rest of the World||NYSEARCA: VWO||30%|
When coming up with this portfolio, I kept it as simple as possible, so that John does not need to keep track of too many counters, but at the same time trying to maximise his diversification.
Let’s backtest this allocation over the past 10 years (assuming a 10,000 starting investment, rebalanced annually).
As you can see, had John started doing this in 2005, he would have a CAGR of 8.88%, and his initial S$10,000 would have turned into S$28,359. His worst year would have been 2008 when he lost 27%, the worst drawdown would have been 41%. He actually outperformed the benchmark S&P500, which had a CAGR of 8.49%, but the S&P took on much higher risks (it lost 36% in 2008, and the max drawdown was 50%).
Source: Portfolio Visualiser
John also decides to compare his returns with his friend who used a Robo-Adviser (let’s call this imaginary 2005 robo-adviser Magic Wealth). Magic Wealth used a far more complex asset allocation (which just for kicks, I used the allocation that AutoWealth gave me from Part I).
Since 2009, John would have returned a 9.85% CAGR, while his friend in Magic Wealth had an 8.69% return. After 0.5% fees, his friend in Magic Wealth would have made about an 8.2% CAGR. So John outperformed his friend by a mind-blowing 20%.
Of course, the S&P500 outperformed both John and MagicWealth because there has been no financial crisis since 2009. As you can see from the 2005 returns above, once a financial crisis kicks in, John/MagicWealth’s portfolio will outperform a pure equity allocation because of the stabilising effect of bonds. I wanted to backtest it further to illustrate this point, but unfortunately the IGOV ETF that Magic Wealth used doesn’t go back beyond 2009.
Chart: Portfolio 1 is Financial Horse, Portfolio 2 is Magic Wealth.
Source: Portfolio Visualiser
|VTI||Vanguard Total Stock Market ETF||43.50%|
|VWO||Vanguard FTSE Emerging Markets ETF||9.20%|
|VGK||Vanguard FTSE Europe ETF||17.50%|
|VPL||Vanguard FTSE Pacific ETF||9.80%|
|IEF||iShares 7-10 Year Treasury Bond ETF||6.90%|
|IGOV||iShares International Treasury Bond ETF||13.10%|
So now John is a very happy man indeed. Because even though he didn’t know anything about investing and financial statements, and he only looked at his investment 1 day a year, he has outperformed his friend in Magic Wealth, he has outperformed the benchmark S&P500 (since 2005), and he has destroyed the returns that his hedge fund friends had.
Note: A reader reached out to me with great clarificatory questions, that I felt was worth replicating here. The original questions, and my responses, below:
1) Your backtesting is based on a single investment with yearly rebalancing. For retail investors, we make multiple investments. How would you deal with the fees vs. opportunity cost (from holding cash) trade-off? In other words, how often would you invest in VTI, VWO, etc.?
Response: When backtesting, I noticed that when rebalancing quarterly, the performance over the past 15 years actually dropped to 8.38% (vs 8.88%). I guess the point is this, rebalancing is important over long periods of time, but to rebalance too often can actually be counter-productive.
For retail investors, I would suggest annual/semi-annual rebalancing, and to allocate a small percentage of your portfolio into risk capital. This risk capital can be used to invest in specific counters you are interested in. I find that this helps to keep one away from excessive tempering with the core portfolio, and serves as a “creative outlet” for trading.
2) Converting SGD to USD (and back to SGD) result in large bank currency fees for retail investors. Do you think Robo Advisors have economies of scale (from narrower bid-ask spreads) from SGD-USD conversions that outweigh their fees?
Response: The Robos typically use Saxo as a broker, and I suspect they have much narrower bid-ask spreads than available to retail. However, I would be highly surprised if this makes up for their hefty fees.
If you are concerned with fees, DBS Vickers/Interactive Brokers provides a very competitive forex spread. There are certain minimum charges that comes with both, but with larger investment sums, these costs as a percentage of your portfolio become trivial.
3) By investing in USD, there’s exposure to FX risk. Returns get eaten up when USD depreciates against SGD. How should a retail investor deal with this risk? Is there a cheap way to hedge?
Response: I do not advise hedging the USD position fully, because part of the intention behind a USD investment is to diversify the portfolio away from Singapore, and you do want the exposure to USD.
However, to address your question, there is no cheap way for retail investors to hedge, as we are not companies like Mapletree with easy access to sophisticated financial products.
The future of Robos
I chanced upon this great article from Wired that I highly recommend you to read if you are serious about investing in a Robo. Basically, it tells the story of Wealthfront, a large US robo adviser that when faced with the prospect of low fees, eventually decide to:
invest 20% of its investors’ funds into an internal “risk parity” fund, which in turn is invested mostly in complex derivatives known as total return swaps. The fees associated with the old strategy averaged out at 0.09%; the new strategy, by contrast, carries a fixed fee of 0.50%, all of which goes directly to Wealthfront, plus the costs associated with buying the swaps. Informed observers say the cost of the swaps could be as much as 3% or even more, depending on the amount of leverage involved.
And it gets better, because
Wealthfront is implementing this change on an opt-out basis rather than an opt-in basis, many investors who signed up for passive management will find themselves put into an active strategy unless they explicitly tell their fund manager that they don’t want to follow its recommendations. Which is a pretty awkward thing to do, especially when a large part of the reason for signing up with Wealthfront is precisely because you don’t feel qualified to make such decisions.
I am not saying that AutoWealth or StashAway will one day go down the same route. But the crux of the issue is that at the kind of fees that the Robos are charging, the business model does not look sustainable.
The problem is that Robo-advisers occupy a very strange place on the spectrum of financial products. Unsophisticated investors are more likely to purchase a product from a financial adviser, because they don’t really understand this space, and they prefer to have a human being to walk them through their investment, and whom they can call when shit hits the fan. You can try to sell them the merits of a robo-adviser, but at the end of the day, investing is not like online shopping. Its not like buying a laptop off Lazada where you immediately save 5% on the purchase price and are pleased. Investing, and compounded returns / superior asset allocation strategies only manifest themselves over multi-decade periods.
At the same time, a true DIY investing enthusiast would not invest in a Robo because he resents the high fees paid, and he values the greater control over his asset allocation that comes with a direct investment in the underlying securities.
To me, the Robo’s ideal target audience is a millennial. Millennials are more likely to trust a computer with their investment than the older generation, they are somewhat financially savvy and can understand the merits of a passive investing strategy. The ideal millennial is also one who doesn’t have the time to monitor his investments closely, and prefers to leave it all to a Robo to do the rebalancing. But as we have seen above, a simple DIY portfolio with annual adjustments can achieve returns that are highly competitive with robo-advisers, and that’s before we include fees. Which I why I suspect that over time, these Robos may need to amend their business model to further appeal to this crowd, because they really do not do enough to justify their 0.5% fees currently.
Fee based income from investment funds are a thing of the past. Hedge funds are facing massive fee compression as they are finding it harder and harder to justify their 2+20 fee structure (2% of asset base and 20% of returns) when a broad index fund charges 0.2% fees and outperforms the hedge fund. The simple truth is that when a hedge fund that charges 2+20 fees, it has to outperform the market by more than 2%. With an S&P500 return of 8%, the fund must return more than 10%, which can be incredibly hard to do.
Here’s a radical idea. What if we throw all our preconceptions about robo-advisers out the window, and restart from the ground up. Financial Horse did exactly that, and here is what I came up with:
The Financial Horse Robo-Adviser
When opening an account, you answer a small list of questions about your income, age and goals. This is used to generate an initial portfolio. However you are completely free to amend the asset allocation as you please. At any time during the year, you can also choose to amend your asset allocation. Based on this allocation, the Robo will perform quarterly rebalancing. The annual fees for this Financial Horse Robo-Adviser is a grand total of 0.0%. Of course, there are premium products being sold. You can choose to take up margin, purchase derivatives to hedge your position (forex risk for example) or purchase cryptocurrencies for a small fee, but the base product is free.
If you thought this was crazy, think again. Robin Hood pioneered zero fee stock trading which everyone though was insanity, and today they are valued at US$5 billion.
I don’t know about you, but I would strongly consider putting my new investments into this Financial Horse Robo-Adviser. What are your thoughts? Let me know if there is demand in the comments section, and I will explore the creation of such a product.
Robo-advisers take the concept of passive index investing and turn it into a product where they can earn fees. I view them as evolutionary, rather than revolutionary. However, in their current form and at the current price point, I don’t see them surviving over longer periods. The margins are just too small.
There are only 2 ways to progress: (1) Increase the fees (which turns them into a pseudo-active managed fund, and is the path WealthFront took), (2) Decrease the fees, to 0.1 to 0.2% (or even better, free or charge). The former allows them to invest heavily into sales and marketing costs to target retail investors, and the latter allows them to target DIY investing enthusiasts and millennials.
The US market is ahead of Singapore in many ways, and I think we are already starting to see these changes manifest themselves in the US Robos.
I will give AutoWealth a 2.5 Financial Horse Rating. I like it more than StashAway because there is no “reoptimisation”, and the fees are lower (for sums below S$450,000). However, a lot of the limitations remain. These are deceptively simple products, but there are a myriad of considerations that go into choosing which product to use. Invest carefully, and keep an eye on this space going forward, because my suspicion is that over the next 5 years, we may see a change in the business model for roboadvisers.
AutoWealth – Financial Horse Rating
Read my original article on StashAway.
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