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Why I am Not Convinced About Volatility and Robos

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In February, I completed a Wealthfront questionnaire to see what kind of portfolio I would be assigned.

I am generally a risk-averse investor, but Wealthfront gave me a very risky portfolio. The combined share of emerging market stocks and emerging market bonds were close to 30%. It also included 12% REITs and 17% foreign stocks, in addition to 20% U.S. stocks. It had no Treasuries (the only thing that could have saved that portfolio when trouble hit in August) – all for an investor who was a 6.5 out of 10 on the risk tolerance scale. (For more details see The Main Weakness of Robo Advisors). Not surprisingly this portfolio has been down about 7.4% since February. While the loss is not large, for a risk-averse investor it is not trivial to lose that much over seven months in the absence of a major market meltdown. I have not performed the same exercise on the Betterment platform, but given the similarity in optimization techniques across robo advisors, it is reasonable to assume that the results would be similar.

Given all this, recent statements by Wealthfront and Betterment strain credibility. When asked about the recent spike in volatility, they claim that it has not affected them at all. Betterment said that “there has been almost no change in client behavior” and Wealthfront’s Adam Nash said that call volume increased a bit, but “not enough to indicate mass hysteria of any kind.” There is a huge gap between call volume “rising a bit” and “mass hysteria” (which would be shocking given that markets corrected only about 10% after a phenomenal bull run), so I am not sure where exactly in that gap the volume of calls at Wealthfront fell. But it is hard to believe that robo advisors were as unaffected as they have portrayed and here is why.

According to Credit Suisse, since July, American households (which account for almost all mutual fund investors) have pulled money both from mutual funds that invest in stocks and those that invest in bonds. It’s the first time since 2008 that both asset classes have recorded back-to-back monthly withdrawals.

Credit Suisse estimates that $6.5 billion left equity funds in July as $8.4 billion was pulled from bond funds, citing weekly data from the Investment Company Institute as of Aug. 19. In the first three weeks of August, those outflows continued, when investors withdrew $1.6 billion from stocks and $8.1 billion from bonds, according to economist Dana Saporta. Credit Suisse characterized it as “an investor revolt.”

Given that revolt how is it possible that robos were a picture of tranquility? One theory suggested that it is because their investors are younger and have a propensity to take risks. But this theory does not hold when we look, for example, at Betterment’s ADV filings.

Betterment had $1.1 billion in January. It had $2.52 billion at the end of July -- a growth rate of 128% over the first seven months of the year. However, from July to the end of August, assets rose a meager 3%, from $2.52 billion to $2.6 billion. Where I live in New York, Betterment advertising is everywhere, including on top of taxis. It is also on the TVs throughout the airports whenever I travel. I am not even talking about the PR activity, which is off the charts as my Google Alerts will attest.

The fact that Betterment’s assets were almost flat in spite of all that money pumped into advertising, begs the question of the supposed immunity of robo advisors to volatility. In a rush to refute the legitimate concerns about risk management, the first wave of robo advisors went too far in denying any impact from volatility – which is just  plain incredible. Unfortunately Wealthfront’s ADV filing for September is not yet available as I write this.

We have not seen any major drop in the markets; they simply corrected a bit after an incredible run. Volatility is starting to increase and in the opinion of well-known investors such as Bill Gross, this is only the beginning. It is still early to say whether the first wave of robo advisors failed the risk test, because we really have not yet had such a test. But in a rush to deny the possibility of that test, they have made an incredible claim – that their investors are completely different from the rest of the investing public. Quite simply, their own numbers belie that assertion.

Daniel Satchkov is president of RiXtrema, a risk modeling and consulting firm, and creator of Advisor BioniX, the first risk aware robo platform for advisors.

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