Wednesday, March 18, 2015

Robo-Advisers

FLG found this post about Robo-Advisers interesting.  He did have an issue with this part:

[Robo-advisers] basically combine simple asset allocation formulas with slick user interfaces on the Web to encourage people to put in their money and leave it there. The algorithms are mostly so simple that a finance doctoral student could implement one in less than a day of coding. That, after all, is the key to passive management. 
 FLG, who is not a finance doctoral student, could probably implement a Robo-Adviser in less than a day.   Well, maybe two days.  He hasn't coded in a while.

FLG does agree with this though:
The real value proposition of robo-advisers is behavioral. Investors are subject to an array of biases, including the temptation to chase returns and to try to time the market. Robo-advisers, with their fancy user interfaces and user experiences, hope to be able to cancel out these biases.
If you think about it, this must be the value-add of robo-advisers. After all, just buying a few ETFs and index funds on ScottTrade, and then forgetting about them for 20 years, will generally give you just as good a return as what the robo-advisers are offering, for slightly lower fees. Index funds basically are robo-advisers without the front-end. Robo-advisers add value if -- and only if -- investors find it much easier to give their money to a robo-adviser than to do the procedure I just described. That’s why robo-advisers are, fundamentally, applied behavioral finance technologies. 
FLG used to be very interested in optimizing his portfolio.  Or perhaps not optimizing, but rather understanding how to optimize it for when he started really looking into his portfolio.    Then one day he realized there are rapidly diminishing returns to getting to optimal.   So, now his portfolio consists of a Total Market Fund, an Ex-US Total Market Fund, and a US bond fund with super low expense ratios.

(He wishes he could find a good Ex-US bond fund, but the fees are always too high.  FLG always assumed the high fees were related to tax treatment of interest income, but has no idea why.)

(Oh, and FLG has a little bit of money in the TSP G-Fund, which he treats as if it were the risk free asset.   His finance professor argued for treating TIPS held to maturity as if they were the risk free asset, which makes sense, but the convenience of treating the G-fund as the risk free asset instead of dealing with actual individual TIPS is too appealing.)





3 comments:

Andrew Stevens said...

Yes, I agree with you. Those three funds are all you need. In fact, I usually recommend an S&P 500 fund rather than a Total Market Fund. You usually get lower expenses on just the S&P 500 and it so dominates the Total Market Funds, that the returns are roughly the same anyway.

Personally, I'm an asset class junkie and I have a portfolio which plays around with weights along various axes, but the amount I expect to gain from this optimization (if anything) is so small that I don't recommend that anyone else should do it. It's almost entirely for my own entertainment.

A lot of ex-US bond funds currency hedge against the dollar which make them more expensive. There are also custody and clearing issues though I'm not sure that justifies the fees. I don't think there are any costly issues with tax treatment, but I could easily be wrong.

FLG said...

Andrew:

Why would bond funds dollar hedge, but not equity funds? At least, I don't think most equity funds do it.

Andrew Stevens said...

Some international equity funds do hedge against the dollar, though you're right that most do not. I would guess the major reason is because bond funds are usually purchased (even foreign ones) in order to get a less risky asset than equities. But if you're taking on currency risk, that's much less true. Also returns in bond funds are much more easily dominated by currency moves. People generally buy bond funds to take on interest rate, credit, and inflation risk, not currency risk. I certainly think there is much more demand for dollar-denominated (i.e. dollar-hedged) foreign bond funds than for dollar-hedged equity funds, whether that's a rational preference or not.

 
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