Going robo: Are you paying your advisor too much?

Editor's Note: David Nelson is Chief Strategist of Belpointe Asset Management and is a Chartered Financial Analyst (CFA).  Nelson is also a Yahoo Finance contributor, and this piece originally appeared on Nelson's Tumblr page.  The opinions expressed here are his.

Launching a full scale attack in what will be known from this date forward as “The Robo Wars,” Charles Schwab’s March entry into the Robo Advisor marketplace has tuned this small subset of the financial industry upside down. Their computer generated Intelligent Portfolios largely following the rules of Modern Portfolio Theory are designed to give retail investors a one stop shopping experience. Unlike other offerings currently available, Schwab advertises they won’t charge an advisory fee. However, with cash as a key component in the asset allocation, it’s easy to see how Schwab expects to turn this venture into a financial bonanza.

What is a Robo-Advisor?

For the uninitiated a Robo-Advisor is a software solution offered by an advisory or brokerage firm that can create an asset allocation model for a client and then implement those recommendations automatically, using in most cases exchange traded funds or ETF’s. For millennials it’s an appealing option that is both efficient and simple.

It’s not surprising that competitors would be quick to point out some of the conflicts. Founder and CEO of Wealthfront, one of the early leaders in the Robo Advisor space Adam Nash says in a personal blog, that Schwab "generates over $1.7 billion per year from net interest revenue, almost 3x what it makes on trading commissions.” He goes on to say, “Schwab’s Sweep Allocation will generally range from 6% - 30% depending on the strategy chosen.”

Schwab was quick to respond to Mr. Nash’s attack defending their asset allocation strategy; “…for a medium to long-term investor, a six to 10 percent cash sleeve in a stand-alone diversified portfolio makes perfectly good sense and is where we think most investors in Schwab Intelligent Portfolios will initially land.”

Financial Advisors - Watch Out!

While we are in the early innings of the Robo Wars, Financial Advisors better take notice and quickly. That sucking sound you hear may be your business leaking assets to these automated hunks of metal. As advisor’s clients’ gain in years, the inevitable transfer of wealth to the next generation will take place. The baby boomer generation is moving from accumulating to spending their wealth. Eventually the assets will pass on to heirs who are increasingly comfortable using technology to make financial decisions. Make no mistake, Robo technology will disrupt the industry.

Is Financial Advice a Commodity?

The truth is that much of what the financial industry offers clients today has become commoditized. Almost anyone can create a simple asset allocation and basic retirement plans. We’ve watched other industries ripped apart by technology so it shouldn’t come as that big a surprise advisors would eventually suffer the same fate.

For now, the Robo offerings from Wall Street powerhouses are generic in nature. After answering a number of questions ranging from goals to risk management, Robby the Robot will spit out a pie chart not unlike what you last received from your high priced financial advisor.

The importance of the pie chart in financial planning can’t be overstated. The inside industry joke; the more pie charts your advisor shows you in a performance review the worse your accounts are doing.

Is this a good deal for investors?

While Financial Planners and Advisors may disagree, for some with very long time horizons a Robo Advisor can play a role. The Process The process is pretty quick. After answering a set of questions designed to ascertain your goals as well as your tolerance for risk the Schwab’s program paints something close to a pie chart with your breakdown of asset classes.

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Even when I created a fictitious client willing to accept negative returns of over 40%, the allocation to cash wouldn’t go below 6%.

The average investor with moderate knowledge and risk tolerance will probably see something close to a 10% cash allocation. It’s clear they intend to capitalize on the net interest margin along with fees on any Schwab ETF’s that find their way into the portfolio. I have no problem with that but the no fee claim kind of rings hollow.

What Can Advisors Do?

Advisors face a rising set of challenges. Clients with unrealistic return expectations, a market that by definition gets closer to the top every day and now robots willing to do your job for free are just a few. Increasingly today’s retail investor seems to have endorsed what I call the "floating benchmark." In rising markets advisor performance is compared to the S&P & Dow while in bear markets T Bills become the comparison.

The first step in solving a problem is recognizing it exists. Once you come to the conclusion that there are secular changes under foot there is much advisors can do to advance both their business and the investment success of their clients.

Modern Portfolio Theory (MPT) is the standard in the industry but even well diversified portfolios can face significant obstacles in the throes of a crisis. As the bear market started to unfold in 2008 correlations started to rise and at times nearly every asset class was positively correlated with each other. In other words when it hits the fan everything goes down.

The next generation of advisors will need to employ new skills and techniques to differentiate themselves armed with something more than a pie chart and smile. Greg Skidmore CEO of my firm Belpointe says it this way; "Top financial advisors will learn how to leverage Robo technology to de-commoditize their business. Average advisors will watch their practices dwindle if they continue to do things Robo can do for less.”

New strategies including tactical asset allocation, advanced estate planning are just two ways an advisor can move beyond being more than a commodity. Greg gives the following example: “Convincing a recent widow to sell that large house she no longer needs is more valuable than her balance between stocks and bonds, an allocation she can purchase for nothing.”

Tactical

Tactical Asset Allocation using separately managed accounts or ETF’s designed to adjust to changing market conditions can be one solution. Most programs are trend following and use buy and sell triggers to keep them in game as long as possible but unwilling to ride the asset class into the toilet.

A chart of the CRB index is a good example. One look at the commodity index over the last few years shows this asset class has been in a secular decline for some time. A typical balanced account would have some portion of assets dedicated to this group. A good advisor using tactical tools can keep his clients from riding an asset class into the toilet.

Matthew Tuttle, CEO and founder of Tuttle Tactical believes tactical programs can offer an alternative, striking a balance between growth and the need to protect capital. “Robo will probably rely on Modern Portfolio Theory to use the past to try and predict future returns. They’re going to come up with yesterday’s portfolio,” he said.

Critics are quick to point out that market timing doesn’t work. Matt follows by saying, “It’s true that the Market Timing Hall of Fame will always be empty. Tactical is about reacting to what the market is telling you. Modern Portfolio Theory is about prediction.”

The debate over which strategy is best will continue and for many a combination of both may prove best. However, one thing is certain. The secular shift in the financial industry is well underway and the Charles Schwab entry shows Robo Advisory has moved beyond the cottage industry status.

The Advisor Advantage

The biggest advantage an advisor brings to the table and often overlooked by investors is the human factor. Your Robo Advisor isn’t going to be able to talk you off the ledge when your stock index fund gets hit or your rollover is down 20% just around the time you get the gold watch.

Your Robo Advisor isn’t going to alert you when your mom who’s been diagnosed with dementia starts to handle her finances recklessly.

The ease with which it takes to establish a Robo account is matched only by how fast an investor can close it. A financial plan is of little use if you don’t stick to it. Studies show that many will succumb to the emotional side of investing and abandon even the most well thought out plan at the first sign of trouble.

Advisors who adapt to the changing landscape, ready to fill client needs that go beyond the pie chart may be worth more than you think.