Your Robo Adviser Is More Active Than You Think -- WSJ

You don't always get the same portfolio, though it might look it, from different robo advisers

This article is being republished as part of our daily reproduction of WSJ.com articles that also appeared in the U.S. print edition of The Wall Street Journal (September 5, 2017).

Robo advisers aren't as mindless or interchangeable as their name makes them sound.

The idea behind these vehicles is to save investors money through simplicity and automation. Robo advisers put together portfolios of inexpensive index funds, and then keep the allocations steady via computer programs or algorithms. The implicit understanding is that a human overseer won't be making choices about how the funds are managed.

But there's a crucial step here that isn't always obvious. Algorithms manage the portfolios, but they don't choose what goes into the portfolios in the first place. People do. That means the robo advisers aren't always passively mimicking the allocation of assets on the global market; human managers are often making active bets on certain sectors, and those bets can make products from different advisers sharply different from each other.

Investors should be aware of the choices that their robo adviser is making, and understand what those choices might mean for their portfolio's performance. With that in mind, we compared the offerings from four of the larger robo advisers, which have 60% to 80% stock exposure, to see how their choices varied from the composition of the global markets.

How they compare

Vanguard Group's Vanguard Personal Advisor Services (PAS) is as simple as it gets. It consists of a mixture of four underlying index funds tracking U.S. stocks, foreign stocks, U.S. bonds and foreign bonds. However, the allocations don't precisely match the makeup of the global market.

Around 40% of the Vanguard stock allocation is in international stocks, while they make up roughly half of the $60 trillion global market. The foreign-bond exposure also falls short of the global asset portfolio. Foreign bonds make up 60% of the $80 trillion world-wide market, but only around 30% of the Vanguard debt allocation.

Of course, there are good reasons to avoid foreign bonds. For example, the foreign-currency exposure gained from investing in any foreign security can add much more volatility than most investors want from bonds. And eliminating the currency exposure with forward currency contracts, as the Vanguard foreign-bond fund used in the portfolio does, can get expensive when foreign bonds yield more than domestic bonds.

So, mimicking the global bond market with a more purely passive portfolio is fraught with difficulties. But avoiding those difficulties or neutralizing them involves an active bet or a deviation from the constitution of global asset markets.

A Vanguard spokesperson says that the company adds international exposure for diversification but stops when adding more doesn't bring any benefits.

Among the robo advisers, Betterment has the international-stock exposure that most closely matches the global market, 50% of its equity allocation. Betterment also puts 8.2% of its equity allocation into emerging markets, close to the emerging-markets share of the MSCI All Country World Index. On the bond side, Betterment had 45% of its allocation in international bonds -- the highest of all the portfolios we examined.

Betterment says that it does offer more international exposure than the average do-it-yourself investor. It also encourages active bets in small-cap stocks and so-called value stocks that trade with lower price/earnings and price/book ratios. With regard to bonds, the firm has less international exposure than the global market would dictate because of the currency risk.

Wealthfront has the second-highest foreign-bond exposure, 38% of its debt allocation. It's also noteworthy that all of Wealthfront's allocation to foreign bonds is in emerging-markets bonds via the J.P. Morgan USD EM Bond ETF, which owns bonds denominated in U.S. dollars and doesn't impose currency risk on its shareholders. That's clearly an active bet on emerging-markets debt.

Real-estate holdings

The Wealthfront portfolio also stands out by having 17.7% of its stock allocation in emerging markets -- the highest in our survey -- and 13% of its assets in real-estate investment trusts, which are roughly 3.5% of the global stock market. The Vanguard portfolio and the Betterment offering had no extra REIT exposure beyond what broad equity-index funds provide. The only other portfolio in our survey with dedicated REIT exposure (a more-modest 5%) was an offering from Charles Schwab's Schwab Intelligent Portfolios.

Schwab had 44% of its equity holdings in international stocks, and 9.3% in emerging markets, the second-highest allocation among the portfolios we examined. In terms of debt, the Schwab offering had nearly 28% of its bondholdings overseas, with more than 10% in emerging-markets debt -- both figures roughly the same as the Vanguard portfolio.

Finally, the Schwab portfolio was unique in our group for having 5% of its portfolio in commodities -- precious metals, specifically -- and 12% of its portfolio in cash.

Typically, only investors with a value bent, who suspect both stocks and bonds are overpriced, are holding cash. If the markets continue to rally, the Schwab portfolios could lag behind. Of course, if markets decline, Schwab's offerings could outperform their competitors.

A Schwab spokesperson says that asset allocation requires more than simply following the percentages of various investments in the global market: It involves understanding the risk and return of each asset class and how their price movements correlate. Each portfolio must then be optimized for different investors' preferences and goals.

All of this means hiring a robo adviser isn't as simple an investment solution as some might think. Even low-cost indexing can mean portfolios different enough that they need some investigation.

Mr. Coumarianos, a former Morningstar analyst, is a writer in Laguna Niguel, Calif. He can be reached at reports@wsj.com.

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September 05, 2017 02:47 ET (06:47 GMT)