Are ETFs the best solution for robo-advice?

By Daniel Tammas-Hastings on Monday 5 February 2018

Savings and Investment

RiskSave's Daniel Tammas-Hastings asks whether digital wealth management might have a future beyond exchange traded funds (ETFs).

RiskSave's Daniel Tammas-Hastings asks whether digital wealth management might have a future beyond exchange traded funds (ETFs).
To the outsider it seems that the robo advice community has concluded that ETFs are the future of automated advice. This seems naive.
The use of technology allows greater precision in risk management at lower cost. It seems clear that an investment universe of individual securities can better provide that than a simple reliance on ETFs. A broader outlook beyond ETFs can reduce risk and increase expected returns. It also can help save on fees. A wider universe is, by definition, in finance jargon of 'equal or greater efficiency'. It is a case of having your cake and eating it, too.
When equity risk is the focus of robo advice, ETFs work reasonably well. They are a cheap way to access a diversified portfolio. But as the inevitable reweighting toward fixed income occurs, there is an assumption that integrating fixed-income ETFs into the mix will be easy. This too is naive. Instead of relying on a package of liquid managed funds or ETFs to provide fixed-income exposure, a more advanced robo-adviser should move to individual securities.
Otherwise, ETFs used in this way are likely to:
Underperform their index. - by definition they are likely to track their index minus fees and transaction costs.
Force a one-size-fits-all risk/return profile on customers. - roboadvisors seem to define risk narrowly from cautious to adventurous. Timing of cash flows is important and a narrow range of fixed income ETFs is not as practical as individual securities or the LDI (Liability Driven Investment) solutions used by the largest institutions.
Be the next collateralized debt obligation (CDO) risk - If the future of advice leads to 'herding' into concentrated positions of ETFs they could be the next cause of systemic distress.
In a market shock, investors want their fixed-income exposure to provide a safe haven. But there is no guarantee, nor any reason to expect that liquidity providers will continue to support ETFs. This could lead to underperformance at a time when the hedging effects of fixed income are supposed to protect investors.
More intelligent portfolios can help investors avoid these hidden pitfalls and make alpha more attainable. By moving beyond ETFs, robo-advisers can help hedge against black swans and reduce systemic risk. RiskSave currently offer granular stock-specific portfolios for investors which aim to move beyond ETFs, it seems the next wave of RoboAdvisors must be ETFs and more.

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