Are Canadian Robo-Advisors Adding or Destroying Value?

In a previous post covering the outrageous fees being charged by Canadian mutual fund managers we concluded that, on balance, active equity money managers are destroying value rather than creating it. Most people would be better off with passive investments, such as index funds or index-tracking exchange-traded funds (ETFs).

But, how would you go about selecting the most suitable mix of index ETFs for your situation? A wise choice would be to consult with a fee-only professional financial advisor who is not compensated by commissions for placing your funds with investment managers. This exercise should take no longer than 1-2 hours, during which the advisor would examine your overall financial profile, anticipated needs, and risk tolerance.

From there, the advisor would recommend a suitable asset allocation for your investments. Perhaps the advisor would also point you to specific index ETFs which you should look into.

How Do You Choose the Best Index ETFs?

Picking specific index ETFs comes down to looking at their investment policies and their annual running costs. While index ETF fees are much lower than active funds, they also vary widely in terms of their annual costs.

Stay Informed

Fortunately, there are some quality resources available to assist.

Mr. Thrifty favours Rob Carrick’s 2020 ETF Buyer’s Guide: Best Canadian equity funds. It’s a terrific resource to investigate promising ETFs and make your choices. Morningstar Canada’s ETF resource page is another great place to read up on the topic. Morningstar includes fixed income ETFs as well.

Monitor Your Investments

Keep in mind that passive investing also requires periodic monitoring. Your recommended asset allocation will stray from the initial levels in your plan as the value of your investments fluctuates over time. In order to maintain a consistent asset allocation ratio, you will need to buy and sell your ETFs periodically.

Enter Canadian Robo-Advisors

A new generation of “robo-advisors” has stepped in to help individual investors maintain their passive asset allocations.

Set It and Forget It

Using computer systems, the robo-advisor recommends your asset allocation, monitors your investments, and does the re-balancing on your behalf, all automatically or with very limited human intervention. The promise is a “set it and forget it” approach to your passive investments and asset allocation.

Similar to the process followed by a personal financial advisor, the robo-advisor would initially put you through an online survey about your financial profile and risk tolerance, and then, typically, categorize you into one out of a fixed set of personas that have common investment objectives. From there, it would determine both the allocation of different ETF asset categories and the specific ETFs themselves. As mentioned, after your initial investment, the robo-advisor monitors your returns and the changes in asset allocation, and re-balances frequently to maintain your target allocation.

Are Canadian Robo-Advisors Right for You?

Sounds great in theory, no?

And, for people who don’t want to put much thought into their investment programme, it can be a good solution. It’s certainly better than trying to pick a winning actively-managed mutual fund.

But the question Mr. Thrifty wants to answer is whether the robo-advisors themselves are adding or destroying value, because their service comes at a price. Their technology and staff are not free, and the annual management fee they charge over and above the underlying ETFs is typically 0.5% — a not-insubstantial sum in relation to the ETF fees themselves.

The Fee Differential between US and Canadian Robo-Advisors

Vanguard is the largest US player in the robo-advisor game. It charges 0.20% annually, less than half the typical fee charged by Canadian robo-advisors.

Canadian Robo-Advisors Are Relatively Expensive

Why do Canadian robo-advisors charge such high fees?

Mr. Thrifty doesn’t have an exact answer. Most likely it comes down to greater competition in the US, rather than the specious argument of better economies of scale. After all, the whole point of a robo-advisor is to substitute computers for humans. Their costs do not scale with the volume of assets under management, yet this “industry-standard” approach of charging a % of assets persists. It would be more logical to charge a fixed annual administration fee, but where’s the upside in that?

Like so many aspects of the Canadian financial services sector, fees are higher than in the US because the big Canadian banks dominate. Even though there are new fintech startups in Canada that are picking away at specific areas where the big banks earn outrageous fees, the startups don’t have much incentive to compete on price because the incumbents can always get into any new market or undercut the startups on pricing of existing financial services, wiping out their business model overnight.

Do Robo-Advisors Add Value?

With a 0.50% annual handicap, the big question is whether the technology being advocated by Canadia robo-advisors actually delivers gains in excess of their fees.

On that front, there’s a very insightful article from 2015 put out by Vanguard Research, entitled “Best practices for portfolio rebalancing” (PDF – 16 pages).

If you don’t feel like reading the entire paper, here is the upshot:

Vanguard research has found that there is no optimal frequency or threshold for rebalancing, since risk-adjusted returns do not differ meaningfully from one rebalancing strategy to another.

As our analysis has shown, the risk-adjusted returns are not meaningfully different whether a portfolio is rebalanced monthly, quarterly, or annually; however, the number of rebalancing events and resulting costs* increase significantly. As a result, we conclude that a rebalancing strategy based on reasonable monitoring frequencies (such as annual or semiannual) and reasonable allocation thresholds (variations of 5% or so) is likely to provide sufficient risk control relative to the target asset allocation for most portfolios with broadly diversified stock and bond holdings, without creating too many rebalancing events over the long term.

In other words, Vanguard found that there is no evidence that the key raison d’être of a robo-advisor, automatic/frequent portfolio re-balancing, delivers value.

*costs involved in frequent re-balancing are primarily taxes, transaction fees, and time and cost to compute the re-balancing amounts.

So What Would You Do, Mr. Thrifty?

Thanks for asking 🙂

Mr. Thrifty likes being in control over his investments and enjoys following the markets.

Given what the research shows, he would pursue the course of implementing the recommendations of his professional financial advisor and investing in index ETFs directly.

He would monitor his asset allocation monthly and reinvest any portfolio income into the index ETFs that have become under-weighted relative to the target.

Twice a year, if market movements have significantly altered his portfolio away from his target allocation, he would sit down with a tasty beverage, do some simple arithmetic, and, unemotionally, buy and sell the ETFs to achieve the target asset allocation recommended by his professional advisor.

Total time estimate: 1 hour per re-balancing calculation session, or 2 hours a year. On a $100,000 portfolio, that would save about $500 annually in robo-advisor fees, or about $250 per hour. He’ll take that trade.

He would also take a moment to review the original survey he did with his financial advisor to determine if his situation has changed substantially. If it has, he would once again reach out to his fee-only adviser to update his plan.

If you don’t have Mr. Thrifty’s temperament or interest, by all means go with a robo-advisor. Just be clear on the costs involved, which are easy to overlook depending on how openly they are being disclosed. If you want to go the robo-advisor route, an excellent resource for surveying Canadian rob-advisors is the Globe & Mail’s Robo-Adviser Guide, which is updated annually.