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ROBO-ADVISORS - JoinCambridge ... Robo-Advisor Selection The first step in evaluating robo-advisor portfolios is to create a sample set of firms from the robo-advisor universe. We

May 22, 2020




  • Looking Beyond the Low-Cost Service

    W H I T E PA P E R


    This new research from Loring Ward, along with tools like our Portfolio Gap Analysis, may help you have conversations with clients about how and why you build portfolios the way you do — and why it matters. Having the right portfolio can make a real difference for investors, especially when it is built not upon an algorithm, but on almost nine decades of data and research, insights from behavioral finance and close relationships with leading academ- well as the expertise and understanding you provide as an advisor.

    Robo-advisors are growing in popularity among millennials by providing a convenient, low cost, automated, algorithm-based investment platform to manage investment portfolios with initial investments as low as $1,000. While it is good news that millennials are starting to manage their wealth early, the growth of their wealth is highly dependent on comprehensive financial planning, not just on the portfolio put together by the robo-advisors. The strength of a portfolio can be measured by its key characteristics such as asset allocation, diversification, stock and bond risk, investment costs, and overall portfolio risk and efficiency.

    When we compare the portfolios from the top five robo-advisors to a benchmark portfolio with several decades of measurable performance, we find that while the robo-advisor portfolios are very well diversified, they also contain several gaps in key characteristics that should be present in well-managed portfolios. Here are the key gaps identified:

    • Large allocation of assets to emerging markets

    • Lack of small-cap and value tilts that earn superior returns over the long term

    • Higher credit risk in the bond portion of the robo-advised portfolios through exposure to junk bonds

    • Significant variations in asset allocation recommendations across ostensibly similar risk profile offerings, particularly with respect to large allocations to either stocks or to cash

    • The above non-risk-adverse allocations reduce overall efficiency of the portfolio, which means the investors might not be getting the optimum return possible for the risks they are taking

  • Robo-advisors are online wealth management platforms that provide auto- mated, algorithm-based portfolio management advice without the use of human financial planners. Robo-advisors have benefited greatly from the growing investor appetite for index-oriented investment products, such as index funds and ETFs.

    Robo-advisors are one of the largest growing segments in the wealth man- agement industry over the last few years. As of February 2016, they were reported to have more than $50 billion of assets under management (AUM) led by passive management industry veterans such as Vanguard and Schwab, as well as venture-backed technology startups like Betterment, Wealthfront and Personal Capital.1

    Robo-advice platforms provide a quick and almost-exclusively-online route to investing in a portfolio, making them particularly enticing for millennials. Robo-advisors typically require initial investments as low as $1,000 – $10,000 and charge extremely low fees — on the order of 40 bps or less annually — while including both global stock and bond exposures, making them popular with cost-conscious investors.

    The convenience and low-cost nature of robo-platforms is difficult to dispute, but there has been little analysis as to the investment quality of their actual investment portfolios. How do these largely algorithm-based portfolios hold up when compared to more traditional wealth management firms’ portfolio construction methods?

    The purpose of this paper is to answer this question by comparing the structure of several popular robo-advisor portfolio recommendations to a well-defined benchmark portfolio.


    1 Alessandra Malito and Ellie Zhu, “Top 5 robo-advisers by AUM,” InvestmentNews, February 25, 2016

    ROBO-ADVISORS: Looking Beyond the Low-Cost Service


  • Robo-Advisor Selection

    The first step in evaluating robo-advisor portfolios is to create a sample set of firms from the robo-advisor universe. We focus on the top five service pro- viders in the U.S. as the appropriate sample set for the study (refer to Table 1 in the appendix). The primary criteria for choosing the sample set for the study are AUM, growth in AUM, number of years of service and brand name.

    Portfolio Analysis Tool

    We entered the portfolio asset allocation of each robo-advisor into a Portfolio Gap Analysis program that uses Morningstar databases for in-depth analysis. The Gap Analysis Program is designed to compare a specified portfolio to a benchmark portfolio and detect deficiencies as well as potential opportunities for improvement. The key characteristics of an evaluated portfolio include asset allocation, diversification, stock and bond risk, investment costs, port- folio risk and efficiency.

    Portfolio Selection

    Traditional advisors as well as robo-advisors provide a range of portfolios based on the risk preferences of investors, where the investor risk prefer- ence is typically characterized as conservative, moderate or aggressive. In this study, a moderate risk portfolio is used to evaluate whether the structure of the robo-advised portfolio is optimized to meet investors’ financial goals.

    We obtained the asset allocation details from each robo-advisor’s webpage, based on what each robo-advisor identified for an average, moderate-risk- profile investor who is investing for retirement (refer to Tables 2 to 7 in the appendix). The asset allocation details are similar to the allocations pre- sented by a study published by Market Watch.2 The robo-advisors use auto- mated programs with detailed questionnaires to help individuals self-select into a risk profile. There is a question as to how well the robo-advisors


    2 Victor Reklaitis, “We asked 4 robo advisers and 4 human advisers for portfolios for the same investor,” Market Watch, May 2, 2015

    ROBO-ADVISORS: Looking Beyond the Low Cost-Service


  • understand the financial situation of an investor in order to accurately determine the risk profile. This critical topic will be discussed in detail in a follow-up paper.

    Benchmark Selection

    Loring Ward’s model portfolio asset allocation recommendations for a moderate risk investor as of September 2016 were chosen as the benchmark for evaluating the portfolio recommendations of the five robo-advisors in this study. Loring Ward’s portfolios are globally diversified as well as spe- cifically tailored to the needs of their clients by financial advisors. They are constructed with DFA mutual funds with tilts towards small-cap and value securities. They embody an Asset Class Investing philosophy that is based on almost nine decades of data, analysis and research, insights from be- havioral finance and close relationships with leading academics, including Dr. Meir Statman and Nobel Laureate Dr. Harry S. Markowitz.


    The Portfolio Gap Analysis we performed of the portfolio recommendations developed by the top five robo-advisors reveals significant gaps with respect to the benchmark portfolio (see Table. 1). The first observation is that Vanguard and Schwab have gaps in two of the 10 key characteristics of the portfolios. Second, the newly established firms Wealthfront, Betterment and Personal Capital have four or five gaps in the portfolios. In the next section, the gaps observed for each key characteristic are discussed in detail.

    ROBO-ADVISORS: Looking Beyond the Low-Cost Service

    4 5

  • Table 1 — Gaps in Robo-Advisor Portfolios with Respect to the Benchmark Portfolio

    Asset Allocation: One of the most important steps in efficient portfolio construction is setting the proper asset allocation. In a study conducted by academics Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, asset allocation was found to account for 93.6% of the variation in portfolio return.3 The proper allocation must be determined with care and in context with each client’s investment goals and personal risk tolerance.

    Gaps in Moderate Portfolios of Robo-Advisors

    Vanguard Schwab Wealthfront Betterment Personal Capital

    Asset Allocation

    Global Diversification

    Stock Concentration Risk

    Stock Risk Analysis

    Bond Quality

    Bond Maturity

    Management Expenses

    Trading Costs

    Portfolio Efficiency

    Portfolio Risk Profile



















    3 Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower. “Determinants of Portfolio Performance.” Financial Analysts Journal 42.4 (1986)

    ROBO-ADVISORS: Looking Beyond the Low-Cost Service


  • The Betterment Portfolio has the biggest gap with respect to asset allocation, with 90% in stocks and just 10% in bonds for a moderate portfolio (see Fig. 1).

    The Schwab Portfolio has an unnecessarily large ‘cash-drag’ for our hypo- thetical investor, with nearly 8.5% of the money in cash.

    Fig. 1 — Asset Allocations in the Betterment and Schwab Intelligent Portfolios Have Significant Gaps Compared to the Benchmark Portfolio

    Global Diversification: On the general issue of global diversification there does not appear to be a gap in

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