There has been a recent surge in firms offering robo-advising to investors with the allure of providing investment advice at a cheaper cost. Robo-advisors are advisory firms that use a computer algorithm to manage accounts using low cost index funds and exchange traded funds (ETF’s). The value proposition behind robo-advisors is that they are really cheap, will keep you allocated according to your risk tolerance and you will supposedly never underperform general market indexes. Robo-advisors also spend a great deal of their marketing effort bad-mouthing active portfolio management which they falsely claim never adds value. This all sounds good but when you take a look at what they are actually doing, there are some inconsistencies as to methods being used. A new interview with Burton Malkiel, published by ThinkAdvisor, illuminates the inner-workings of a prominent robo-advisor.
Professor Burton Malkiel is now the Chief Investment Officer of Wealthfront. Malkiel gained fame as the author of “A Random Walk Down Wall Street” which was a key driver in bringing passive investing through index funds to the forefront. He is still an avid supporter and proponent of index funds and states at the end of the interview that his own investment dollars are predominately in index funds. What becomes eye-opening is the response given to a question about allocations that Wealthfront currently holds in emerging markets and how that is different from MSCI (a firm that sets and provides indexes accepted and utilized by the investing world).
The question posed by the interviewer was about allocations that Wealthfront is currently putting in emerging markets and how that differs from what MSCI has listed as the world’s overall market cap for emerging markets. There is an eight percent difference between these two percentages which is a large disparity. Malkiel says that the reason for the difference is because they look at and utilize two additional factors, namely a float-adjusted market cap (which attempts to account for the fact that not all shares of companies are available to the public for trading) and the Shiller P/E (price to earnings) index (emerging markets are selling at 35% of the PE of the US P/E and thus get a higher weight in the portfolio). Wait, doesn’t that last one sound like a value investing strategy? The very kind of strategy that indexers, including robo-advisors, claim doesn’t work. To further muddy the waters, when asked about the U.S. Bond market index Malkiel cites that the index now is over 60% in U.S. Government bonds and that Wealthfront is adding more corporate bonds to their portfolios which again is a value play.
The criticism is not in these strategies or philosophies in themselves but rather in the way that robo-advisors market themselves as indexers and claim that active managers cannot perform better than weighted indexes. Here is Wealthfront imposing their valuation work on indexed portfolios contradicting the robo-advising philosophy of being a passive investor. It is hypocritical to berate active management one minute and then turn around and put it into practice in your firm’s portfolios to produce better returns. There is prudence in having good active managers with a value tilt so that some of the pitfalls of misallocation of capital caused by indexing can be sidestepped. This prudence is being ignored by the proponents of passive investing and by the financial press to the detriment of the investing public.
In summary, it is always important to know what you are paying for and if there is value in that service or goods purchased. Index funds are great portfolio tools and can be useful depending on what needs to be accomplished. It takes much longer than most investors realize for value to surface, sometimes years. I have been investing money for others as a fiduciary for 30 years and I assure you, value is always eventually recognized by the markets. As always, transparency is important and knowing what the costs are and what benchmarks are being used is critical. One of the concerns with robo-advisors is that there is no way for an individual investor to evaluate the computer algorithm used by these firms to manage the accounts or the benchmarks used by these firms. Lower cost doesn’t always equate to quality and rarely does something that is cheap provide long term value.