Investors’ love affair with exchange-traded funds has helped
fuel the popularity of low-cost automated investing. But automated doesn’t mean
uniform. Ask three computers how to set up your portfolio, and you’ll get three
different answers. Understanding the differences can help investors decide
which of the so-called robo advisers is best for them.
Modern portfolio theory, the foundation for all the robo
advisers, attempts to maximize returns and minimize risk by spreading money
around a diverse mix of asset classes and regions. That’s why ETFs are so
handy. They are baskets of securities that track a given index, whether that be
the S&P 500, the Barclays Aggregate or any one of dozens of others. Put
together in a portfolio, they are a relatively simple and low-cost way to track
a broad array of securities all at once. There are differences in how each
adviser approaches what mix of funds to use, however.
How many ETFs in the
pot?
At their most basic, the robos build portfolios of ETFs
using an approach called strategic asset allocation. This is a buy-and-hold
style that factors in an investor’s risk tolerance, investment time horizon and
objective, and makes a portfolio that has target percentages for each asset
class. The portfolio is continually rebalanced back to those original
percentage targets. But some advisers use only a handful of ETFs to construct
portfolios, while others use as many as 20. And there is a long-running debate
on whether small-cap stocks and emerging-markets investments are good for
portfolios. Both add risk and can have higher costs than investments in
larger-cap stocks and developed markets—but both offer the potential for higher
returns.
Among many variations on these themes, Wealthfront Inc., a
San Francisco-based provider of automated portfolios, skews to emerging
markets, while its rival, New York-based Betterment LLC, puts more small-cap
stocks in its portfolios in addition to a smattering of emerging-markets funds.
The robo portfolios designed by Charles Schwab Corp. add
another twist: fundamental asset allocation. Many big ETFs are weighted by
market cap—the bigger a stock’s market capitalization, the bigger the
percentage of that security in the fund. Fundamental ETFs are weighted
according to different measures, such as sales or revenue, an approach that
some analysts believe can give more weight in a portfolio to undervalued
stocks. Schwab’s Intelligent Portfolios range of robo offerings, for example,
includes holdings of fundamental ETFs that invest in the same securities as
their traditional counterparts, just in different proportions, and they sit
alongside traditional ETFs in the same portfolio.
Critics of this “smart beta” investing approach point out
that fundamental funds are more costly than traditional ETFs. Fundamental funds
also have to be more actively managed to stick to their index, where
market-cap-weighted funds naturally rebalance; that makes fundamental funds
less tax-efficient.
Is the best the best?
Andrew Rachleff, Wealthfront’s co-founder and chairman,
says some investors get hung up on whether the ETFs used to build robo
portfolios are the best performers in a category. One problem with that, he
recently wrote, is that the best-performing fund might closely mimic the
movements of other funds in the portfolio, which doesn’t help maximize the
portfolio’s return over a range of market conditions. A better mix of funds
includes some whose movements aren’t so closely correlated, Mr. Rachleff says.
Taxes are also a consideration for taxable accounts, he
says. A manager estimating pretax returns might be tempted to overlook
relatively low-yielding municipal bonds in favor of corporate bonds. But based
on after-tax returns, the muni bond, with its federal and state tax-exempt
benefits, might be a better investment.
The biggest controversy has been the role of cash in a robo
portfolio. Many advisers (humans, that is) maintain a sliver of cash in a
client’s portfolio to handle fees and provide liquidity. But Schwab got people
talking when it disclosed that its Intelligent Portfolios have 4% to 30% cash
as part of their asset allocation. Schwab makes money for itself by investing
at least some of that cash overnight. It is also able to offer its robo product
free of fees, unlike other robo firms, which charge 0.25% to 0.5% of a
portfolio’s assets annually.
Rivals point out that uninvested cash can be a drag on
performance. But a Schwab spokesman says cash plays an important role in a
portfolio as a source of stability, downside protection and diversification.
The real drag on returns, the spokesman says, is when investors pay too much in
advisory fees.
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