The Unanswered Question About Robo-Advisors

By James Watkins III Markets Fool.com

Digital investment services, more commonly known as robo advisors, are among the hottest products in the investment industry. At the end of 2015, Aite Group estimated that robo advisors had $53 billion dollars under management --and BI Intelligence forecasts that by 2020, robo advisors will have over $7 trillion dollars under management.

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Robo-advisors are computer-based asset-management programs that use algorithms to generate asset allocation recommendations. The original purpose of robo-advisors was to provide affordable account-management services for ordinary investors, who often cannot meet the minimum account requirements of traditional investment advisors -- or pay their hefty fees. Robo-advisors often have low or no minimum account size requirements,and they usually charge an annual asset management fee of 0.25% to 0.50% of the total value of the account.

These low fees give robo-advisors a considerable edge -- yet investors could find that the lack of human oversight leaves their portfolio at risk of serious losses.

Image source: Getty Images.

Algorithms can't do it all -- yet

The primary goal of wealth management should be to provide investment advice and/or asset management services that provide customers with an opportunity for both upside potential for investment gains and downside protection against significant and unnecessary financial loss. Where traditional investment advisors may offer a range of asset management services, robo-advisors typically only offer a much limited range of services on the accounts they manage.

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The primary wealth management service that robo-advisors offer is periodic rebalancing. Rebalancing involves shifting assets within a portfolio to restore the portfolio's original asset allocation percentages. While rebalancing is a widely accepted and generally beneficial wealth-management strategy, history clearly shows that the performance of the stock market is cyclical, with the market alternating between bull and bear markets.

The robo advisors' single-strategy approach to wealth management, combined with the fact that they have no proven track record in bear markets or significant market corrections, leads to the yet-unanswered question: How will robo advisors perform under adverse stock market and/or economic conditions? Therefore, the question remains whether rebalancing alone is enough to protect investors from significant losses.

In order to better protect their financial security, investors choosing to work with a robo-advisor should look for a robo-advisor that offers at least one of these features:

  1. An additional level of service, for an additional fee, that combines the robo-advisor's rebalancing program with proven defensive investment strategies to reduce the impact of the inevitable bear markets and market corrections
  2. The opportunity to personally make proactive changes in your account to protect against the risk of market downturns
  3. Educational materials that alert investors that the robo-advisor does not offer proactive and comprehensive wealth-preservation services and that this may expose them to risk in market downturns.

You may not understand what you're getting

Another related concern that has been raised by regulators is whether the portfolios being recommended by robo-advisors are too inconsistent and therefore potentially too aggressive for some investors, with too much exposure to stocks and other riskier investments. Since equities would presumably suffer the largest losses during a bear market or market correction, this is a potential issue that investors need to consider.

Robo-advisors are quick to point out that their client contracts clearly describe the services they provide. However, the typical clientele of robo-advisors -- i.e., relatively inexperienced and passive investors -- may not understand the nature of those services and the potential risks those services may expose them to.

Robo-advisors do provide a meaningful service to investors who want help managing their portfolios but can't (or don't want to) pay the price for a traditional advisor. However, the limited nature of the services that robo-advisors provide has raised concerns among regulators that robo-advisor customers may not understand the potential consequences of such limitations, specifically any investment risks and potential financial losses.

Investors who decide to work with a robo-advisor should make sure their portfolio can withstand a bear market by looking for a robo-advisor that either offers proactive wealth preservation services or allows a customer to personally make changes in their portfolios to protect against unnecessary investment risk.

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