Here at BackEnd Benchmarking, we have recently released the fourth-quarter 2017 edition of The Robo Report. In this report we took an in-depth look at two-year returns of seven different portfolios with a full two years’ worth of data. The fourth quarter of 2017 was a strong finish to a strong year in the equity markets and for the digital advice industry as a whole. Since the end of the year, market turmoil has shaken equity markets and tested the systems of robo-advice providers. Despite some technical issues experienced by some robos during recent tumultuous market days, digital advice is expanding across the financial services landscape. Interviews this quarter with TD Ameritrade, Merrill Edge and Schwab gave us insight into where these products are fitting in among client bases, and we are starting to get a clearer picture of where digital advice products are gaining the most traction.
On Monday, February 5, the Dow Jones industrial average was down as much as 1,500 points during the trading day. It was reported that the two largest independent robo-advisers, WealthFront and Betterment, experienced outages on their websites and clients could not log in to view or take action on their accounts for brief windows during the day. Although WealthFront and Betterment are relatively new players in the financial advice landscape, they were not the only institutions that had issues related to website traffic and volume. Fidelity, Schwab, Vanguard, T. Rowe Price and TD Ameritrade were all reported to have had issues either with website response times or with accessibility due to high traffic volumes. This is not the first time that Betterment has been in the press following a volatile market period; they suspended trading in reaction to a spike in market volatility resulting from the Brexit vote in 2016. This proved to be a controversial decision and spurred a discussion about how automated investing tools will react in times of uncertainty and volatility.
Although the recent website outages should be addressed and spur a conversation in the investment community about how automated trading and digital advice products will react in down markets, we do not believe this recent incident is a game-changer for digital advice. New technology and products go through periods of growing pains, and it should be expected when a new technology achieves rapid growth and adoption that not every step of the rapid growth period will be smooth. Years ago, when online trading was first taking the financial industry by storm there were similar incidents of lost accessibility. We point out to readers that, although accessibility issues were not as large as what Betterment and Wealthfront experienced, industry juggernauts like Schwab, Fidelity and Vanguard were reported to have run into volume-related problems on their brokerage websites during this time period as well. This incident will hopefully create a fruitful discussion in the investment community about these new technologies and products. We are confident that extensive reviews of the problems that arose are being conducted at the institutions that had issues, and there will be modifications made to platforms to better prepare them for high-volume periods in the future. These institutions have work to do in restoring investor confidence and preparing themselves for the next period of high volatility and the resulting increase in website traffic.
The most prominent robo-investing products are typically, and appropriately, marketed as a long-term investing solution. Clients looking for a manager who will attempt to time the markets are better off with something other than the typical robo-advice product. That said, timing of markets is notoriously difficult and most research supports the conclusion that individual investors who divest from markets during periods of volatility do not fare as well as those who stay invested. Most advisers, robo or otherwise, agree that a better strategy is to properly align a client’s risk tolerance with the level of risk in their portfolio, while keeping sufficient cash reserves to help clients stay invested during down market periods.
It can often be difficult for individual investors to stick to this strategy during times of uncertainty. When differentiating themselves from a digital advice product, traditional advisers will often cite that they are able to communicate and coach clients through difficult times in the market as a comparative advantage. The jury is still out on how effectively a robo-advice provider can communicate with clients to help them stay invested through down markets. To be honest, we were disappointed with how few client communications we received from our universe of robo-advice providers on February 5th and 6th. We encourage robo-advice providers to make more timely communications with clients.
All this being said, many providers like Schwab and Betterment have product options that include the ability to speak with live advisers and planners. Vanguard, the dominant player in the market, does not have a digital-only option and every client of Vanguard’s Personal Advisor Services has access to a live adviser. Many other robo-advice providers have always, or currently have, different levels of service and access to live advisers. Transitioning to hybrid models or introducing a hybrid service in addition to digital-only offerings was one of the largest trends seen in the digital advice industry in 2017. Those clients who are looking for a low-cost solution but do not want to give up access to live advisers can find increasingly more options within the robo-advice landscape.
This quarter we added portfolios from Zacks Advantage and T. Rowe Price. Next quarter we will be publishing the first round of data on portfolios from USAA, Wells Fargo, Morgan Stanley, United Income and Capital One.
Over the past year we have seen many robos introduce an option to invest in a socially responsible portfolio and we have opened three portfolios with this theme. In our next report we will publish results from socially responsible portfolios at Morgan Stanley, Betterment and TIAA.
Additionally, we have discontinued coverage of the E*Trade Hybrid portfolio as this strategy is no longer available to new customers. We have also changed how we cover the Ally Financial (previously TradeKing) portfolio. Ally Financial acquired TradeKing in 2016. At the end of the first quarter of 2017 and after the acquisition, we witnessed a significant change in strategy. In the interest of representing to our readers the portfolio and performance they would receive with Ally Financial, we now report the Ally Financial account as of the second quarter of 2017, after the transition. We still publish the performance on the portfolio before the transition under “TradeKing” in the addendum.
At The Robo Report we always encourage investors to seek long-term performance. In our fourth-quarter report we focused on the long-term results of our seven portfolios that have two-year track records, but still produced a table (Figure 1) showing the top robo-performers during the fourth quarter.
The past two years have been strong for equity markets both at home and abroad. The S&P 500 index returned 36.4%, while the MSCI emerging markets index returned 53.67% and the MSCI EAFE index returned 27.7%. In 2016, we saw growth concerns fueled by Brexit and concerns about declines in global trade following the election of Donald Trump with his protectionist rhetoric. International stocks in 2017 were driven by positive economic numbers across the globe and gave rise to the term “synchronized growth,” helping both emerging and developed market stocks post fantastic returns for the year.
Value and growth stocks were split between the two years, with 2016 being the year for value to outperform and 2017 being the year for growth fueled by large upswings in large tech companies. Across the two-year period, growth edged out value, but not by large margins. Although a preference for slightly overweighting value funds can be seen in some of our portfolios, among this group of seven portfolios with two-year return numbers, there is not a significant weight toward or away from value.
Although small-cap stocks outperformed their mid- and large-cap peers over the two-year period, it was not by large margins and market capitalization was not a main driver of performance in our portfolios.
Fixed-income allocations in our portfolios showed a much larger distribution of returns than the equity portion of the portfolios. The Federal Reserve has continued a moderate and steady approach to rising interest rates throughout the two years. In the fourth quarter of 2016, we saw municipal bond prices fall significantly surrounding the election of Trump and the resulting expectation of a tax cut that reduces a municipal bond’s tax advantage. A pickup in economic growth abroad, reactions to the election of Trump and tax reform and positive economic numbers both at home and abroad have kept business confidence high and rewarded those managers who chose high-yield and international fixed income in their portfolios.
Schwab came out on top for the two-year period ending December 31, 2017, while Acorns lagged the group over this time frame.
The two best-performing equity portfolio returns were Schwab and SigFig, thanks in part to their holdings of the largest dedicated emerging market allocations—7% and 13% of the total portfolio, respectively. Schwab’s fixed-income portfolio, which holds significant positions in high-yield and international debt, paid off over the historically stable and upward markets of 2016 and 2017.
SigFig’s and Schwab’s fixed-income portfolios held the top two spots again, with an 11% and 14% return, respectively. Both portfolios invested in international debt. Of particular note, SigFig had an 8% allocation to an emerging markets sovereign debt fund and Schwab had a 4% allocation to emerging market debt funds that had total returns above 19% and 24%, respectively. Schwab also found success investing in a high-yield fund that had a total return north of 18%.
Acorns, on the other hand, made changes to our portfolio over the two-year period that were ill-timed. One of those decisions was to diversify away from a concentrated position in emerging markets early in 2017. If they had held onto that large allocation, it would have paid off as the MSCI Emerging Markets Index returned more than 53% over the two-year time period. Instead, Acorns ended the year with just a 3% allocation to emerging market equities and lagged the group in performance.
Betterment, Vanguard and WiseBanyan all have between 4.5% and 6.0% allocated to emerging markets. Betterment and Schwab have some of the largest allocations to international as a whole, with around 30% of their total portfolios allocated to international funds.
Choices in the level of risk also help explain the wide dispersion of returns. It is not surprising that Schwab, who has allocated large portions to international and high-yield funds, has outperformed Vanguard, who has stayed in historically much safer domestic municipal bond funds during a period of growth and confidence in the markets.
The number of ETFs used in a style map is unrelated to the number of portfolios analyzed. The equity style map gives an idea of the market cap and value/growth weighting of the portfolio. To do this we used six ETFs, a value and growth focused ETF for each small-cap, mid-cap and large-cap which comes to six total funds to create the map.
We used eight ETFs in the fixed-income portion of the portfolio as we wanted to show more dimensions to the bond portfolio. It is difficult to break apart the fixed-income market along clean lines such as growth versus value or market cap like can be done with equities. Treasury inflation protected securities (TIPS), municipal bonds, corporate, high yield, etc., all behave differently depending on market forces, and it made more sense to include more categories to make the results of the map more accurate. That is why we included more ETFs in the fixed-income portion than in the equity portion.
Adjusting Returns for Risk
Schwab has achieved the best risk-adjusted returns as measured by the Sharpe ratio over the preceding two-year period. A higher Sharpe ratio implies better risk-adjusted returns. Their allocations internationally in both the fixed-income and equity markets have increased their return without proving volatile investments.
SigFig and Betterment, who had the second- and third-highest Sharpe ratios, respectively, also have higher-than-average international allocations and found success in fixed-income markets abroad. Vanguard had the lowest standard deviation in the group. This may be due, in part, to their holdings in a few very broad-based funds. With just two equity funds that have global coverage, it is not expected that the individual funds will be volatile. Furthermore, Vanguard has a conservative fixed-income portfolio made up of three municipal bond funds. Compared with some other portfolios that hold high-yield and emerging market fixed income, Vanguard’s is expected to have lower risk.
In light of recent down markets, we still believe that robo-advisers offer a compelling value proposition with low-cost access to well-diversified portfolios. From our interviews with TD Ameritrade, Schwab and Merrill Edge, we are learning that these products are finding success at attracting new-to-investing and previously self-directed investors. The attraction cuts across traditional demographic lines and is drawing in investors of all ages, not just millennials.
Many robo-clients at institutional firms are upgrading services from self-directed brokerage platforms to their first professionally advised portfolios. Robo-advice products may be stealing less of traditional advisers’ clients than previously thought, but instead increasing the market for professional advice by expanding into households with lower levels of assets and attracting self-directed clients by offering a low-cost entry point to professional management. With Morgan Stanley and Wells Fargo recently launching products and JPMorgan Chase reportedly releasing a digital advice offering this year, the forward march of digital advice continues, further solidifying a permanent position in the financial advice landscape.