How a Clever ETF Application Changed the Way People Invest
- Per the latest Pew Research Center survey, a majority of Americans are skeptical of automation. In the investment world we find that Robo Advisors predominantly use an automated approach and take a clever path utilizing Exchange Traded Funds (“ETFs”). In doing so they are able to construct portfolios for millions seeking to embark or continue their journey toward financial independence.
- Portfolios offered by automated Robo Advisors vary in risk from Conservative to Aggressive and, in most cases, are constructed entirely from ETFs.
- Levels of expected return for Robo strategies are as follows: Aggressive 9%, Moderately Aggressive 8%, Moderate 7%, Moderately Conservative 6%, Conservative 5%
- ETFs that Robo Advisors select are low cost, diversified investment vehicles. For an all in cost of approximately $20/yr per $10,000 you can be diversified across stocks, bonds, sectors, countries etc. This is spectacularly affordable and was unimaginable 20 years ago
- Robo Advisors do not charge re-balance or wire fees. The only two fees you pay are the management fee which we’ve seen run from $0-12/year to 0.25% on your balance. Platforms rarely charge over 0.25% but some do land at 0.50%. The second is the ETF fee (0.07% to 0.13% on average depending on the portfolio you choose) but some could be higher.
- Assets you own at robo advisors are held at the custodian for safeguarding and you’ll typically find that the platform of your choice is SIPC insured.
After Threadvest published the research about Robo Advisors being the innovative approach in finance on Medium, we have been receiving many questions regarding their safety. There are questions about safety both in terms of entrusting your money with an automated platform, as well as safety in the performance of portfolios robo advisors choose. This is a natural concern according to Pew Research Center’s survey noted above which says that 72% of Americans are skeptical of automation. Robo advisors have gotten more popular in the past few years, however some skepticism about automation persists. We will try to cover most of the questions relating to what they do, how they do it, portfolios they offer, what to expect, insurance provided on your money and some special capabilities provided to lower your tax bill.
A. What do Robos really do?
Financial advisors take into account (a) how much money you have (b) how much you make (c) how old you are and what your life expectancy is. That determines how much money you will need in retirement. In order to get to estimate/calculate that amount we need to know how much to save each month and the rate of compounding you need to save enough money for retirement. The rate of compounding is called internal rate of return (IRR) and is effectively your return on the investment. If you want to test it out there are a few calculators out there. (Hint: in the linked calculator, make sure to play around with optional features).
B. How are portfolios constructed to reach IRR?
Once a financial advisor figures out how much money you have now, save and need to have to spend in the future, there is usually a growth number that you need to earn in the market to reach it. It’s very unlikely to be able to save enough money for retirement without compounding. This is exactly where Robos add value. They offer diversified portfolios that are optimized in a way to hit that IRR across your investment horizon. Let’s say you need 8% return to have enough money to retire. This would correspond to a roughly 70% stocks and 30% bonds portfolio. Robo Advisors have multiple portfolios for each return rate required and once you enter your preferences they offer you the portfolio that is the most suitable for you.
C. What do these portfolios include?
Robo Advisor portfolios are generally similar in that they consist of ETFs and are diversified broadly across the market. Attached is a sample portfolio from Acorns. Let’s dig into some components of this breakdown
Each one of the asset classes consists of an ETF, which are composed of individual companies. You end up holding hundreds of companies that are diversified enough so you are not concentrated in any single holding.
Large Company Stocks: Vanguard S&P 500 ETF (VOO), holdings include Apple, Microsoft, Alphabet, Amazon, Berkshire Hathaway etc.
Small Company Stocks: Vanguard Small-Cap ETF (VB), holdings include Domino’s Pizza, Dunkin Brand, Jet Blue, GoDaddy, GrubHub etc.
Emerging Market Stocks: Vanguard FTSE Emerging Markets (VWO), holdings include AliBaba Group Holdings, Naspers Limited, Baidu Inc, Tencent, Vodacom Group etc.
Real Estate Stocks: Vanguard REIT ETF (VNQ), holdings include Public Storage, Iron Mountain, CBRE Group, American Tower Group, Prologic Inc etc.
Government Bonds: Treasury Bond ETF (SHY), holdings are debt obligations from US Treasury.
Corporate Bonds: iShares Corporate Bond ETF (LQD), holdings include debt obligations from companies such as Visa, Apple, Google, Amazon, JP Morgan etc.
International Large Company Stocks: Vanguard VEA ETF (VEA), holdings include Toyota, Samsung, Daimler, Volvo, Nestle etc.
D. Why do Robos invest in ETFs?
The combination of ETFs in this way allows you to be diversified across both stocks and bonds, large and small companies, U.S. and international exposure etc. We have covered why we think investing in ETFs is advantageous to picking single stocks in our medium article. Generally, diversification helps in mitigating losses associated with a single stock. In one particular example, during the recent run-up of the cannabis market, an investor had to choose between investing in single stocks and investing in ETFs. Although, from a return perspective investing in single stocks could be more profitable, as evidenced by example where $1,000 investment could’ve made over $20,000, it also carries more risk especially investing in the long term. Consider that an average life of Fortune 500 company is only between 40 and 50 years. You never know when a company could become irrelevant and your returns suffer. Therefore, investing in broad sectors provides security from that perspective.
E. Other than diversification what are other advantages of this portfolio?
Portfolios constructed like this also have two additional benefits:
1. Invest in a broad market with low fees and keep more of your money for yourself
Attached are the costs for portfolios constructed with ETFs in Acorns:
- Aggressive Strategy (0.07%/yr ETF costs, $7 per $10,000 managed each year)
- Moderately Aggressive Strategy (0.08%/yr ETF costs)
- Moderate Strategy (0.10%/yr ETF costs)
- Moderately Conservative Strategy (0.11%/yr ETF costs)
- Conservative Strategy (0.13%/yr ETF costs)
That is spectacularly affordable! Only 15 years ago having a portfolio like this was unimaginable without the high cost to construct that eats into your returns. Right now, for ~$20 a year for each $10,000 you can be fully diversified across an asset spectrum. Now that truly lets more of your money work for you!
2. No transaction costs for re-balances
Robo Advisors give you the ability to re-balance your portfolio. Say you were investing in growth that is 80% stocks ETF and 20% bonds ETF, and you decide to move to something more of Capital Preservation strategy which would be around 30% stocks ETFs and 70% bonds ETF. Operationally, if you were to do that yourself, it would be a lot of buys and sells. You would have to shift your whole portfolio around. Traditional brokerages charge you per each trade, while automated platforms do not. All you need to do is put in a request to re-balance, and it is all done for free.
F. What are the historical robo advisor performance?
Robo advisors use a few levels of risk taking that you can specify. Generally the question is, what is the breakdown of these strategies between stocks and bonds? We are using Acorns as an example, and although they vary across platforms, they are similar
- Aggressive (90% stock ETFs, 10% bond ETFs)
- Moderately Aggressive (72% stock ETFs, 28% bond ETFs)
- Moderate (54% stock ETFs, 46% bond ETFs)
- Moderately Conservative (40% stock ETFs, 60% bond ETFs)
- Conservative (20% stock ETFs, 80% bond ETFs)
Each one of these strategies offers different average return levels and also different level of risk. If you recall in the beginning of our article we discussed how financial advisors solve for IRR (internal rate of return) that you need for your money to grow enough into retirement. Similarly, each one of these portfolios has an expected rate of return. As seen from the infographic below, attached are 5 strategies and level of expected return for each of them going back to 2006.
As you can see from the stats table, each of the strategies corresponds to some level of return. If we rounded up or down, we would get a very nice picture of Aggressive average return 8%, Moderately Aggressive 7%, Moderate 6%, Moderately Conservative 5% and Conservative 4%. It is not a coincidence the numbers work out in that order and a gradual step down is very much expected. The question that financial advisors try to answer, and now automated platforms are too, is which one of these returns would provide you enough compounding for you to retire comfortably.
You may even ask yourself: “How high of a return do I want a year to retire?”. Is it 8%, or maybe 5%? From there, you may choose one of these portfolios and let your portfolio grow.
Now, you may ask a question about how much fluctuation you are supposed to expect if you were to choose 7% average return for example. We answer that question in the Moderately Aggressive Strategy Analysis in the infographic above. As you can see, the very bad year which was 2008, you would’ve lost 29% and at one point would’ve been down 41%. In other years you would be up 24% such as 2009 and even at one point 72%. However, we need to be careful when we think about these Max figures. They assume that you bought at the bottom and waited for a year, and the max loss figure assumes you bought at the top and waited for a year to sell it.
Let’s try to illustrate through graphs yearly robo advisor performance of each of these strategies
Aggressive (average annual return 8%, 2006 – 2018 range: -35% to 31%):
Moderately Aggressive (average annual return 7%, 2006-2018 range: -30% to 26%):
Moderate Strategy (average annual return 6%, 2006-2018 range: -21% to 21%):
Moderately Conservative Strategy (average annual return 5%, 2006-2018 range: -12% to 14%):
Conservative Strategy (average annual return 4%, 2006-2018 range: -4% to 9%):
G. What about the safety?
Now that we covered various portfolio returns, let’s turn to safety. Threadvest believes that automated robo advisors have much less operational risk than other automated solutions (such as self driving cars). How about insurance on the securities and cash you have at the platform? You need to check whether the platform has SIPC insurance. SIPC insures investment accounts for up to $500,000. For example, the platform featured on our website Acorns has SIPC insurance and so do Wealthfront and Charles Schwab.
H. What if I had more than $500,000?
When we talk about $500,000 it only means that in case a platform was to shut down, and your assets could not be recovered, the insurance would step in. Assets you own at platforms are typically held at the custodian in street name. This is very important to know, as it means that if anything were to happen to a platform, your segregated assets at the custodian would still be safe. For example Acorns utilizes the Royal Bank of Canada (RBC) to have your funds and securities. RBC is a Canadian bank with more than $1 trillion in assets. Therefore, the likelihood that SIPC would even be triggered in this and similar cases is very small. See below how rarely brokerage assets could not be recovered and needed SIPC proceeding. Especially in recent history, the average of new cases has decreased down to 1.3 per year.
I. What is Tax Loss Harvesting?
Tax Loss Harvesting is a practice of selling securities that have experienced a loss and replacing them with securities that are similar. This way you keep your portfolio allocation given that you replaced the security with a similar one, but at the same time “harvest” tax losses that you can claim. As a reminder, as long as you hold your portfolio and do not sell you would not be subject to taxation. Once you sell and realize a gain or a loss, you either need to pay taxes on gains or you get capital loss you can claim to offset some of the gains. The algorithm in robo advisors continually scans for opportunities for tax losses to be harvested and notifies you when these capital losses have been harvested so they can be used against the capital gains. If you are a buy and hold investor you are not to be expected to have tax events often given that ETF portfolios are tax efficient. Meaning, they do not have taxable events as long as you do not sell them.
J. If I needed the money, when can I have it and what should I be mindful of?
If you decide to close your robo advisor (or any other investing account), it’s important to know that your portfolio will be liquidated and that you will be subject to taxation for any gains you had. There are usually no withdrawal or wire fees. It would typically take a day or two for your portfolio to be liquidated, your cash to settle in Robo Advisor’s account and for the wire to go through. The whole process time varies, but it goes anywhere from 3 to 5 business days. Ideally, you want to keep your money in an investment portfolio to allow it to grow without withdrawing it. The compounding is a very powerful tool finance has given us!