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06/17/2020

Q1 2020 – The stock market’s worst quarter since 1987: How Robo Advisors performed and the implications for traditional wealth managers

             

The outbreak and rapid proliferation of the coronavirus pandemic rattled global financial markets in the first quarter of 2020. Markets experienced heightened volatility and sharp selloffs as evidenced by the VIX ‘fear’ index rising as much as six times its value, and the S&P 500 dropping 34% between Feb. 19 and March 23, only to rebound and close out the quarter at a loss of 19.6%. The traditional notion is that robo-advisors would underperform in such market conditions, due to the absence of seasoned investment professionals to actively navigate the downturn. Moreover, robo advisor funds are typically comprised of passively held investment vehicles such as ETFs which are predominantly owned by retail investors, and hence expected to deteriorate more rapidly than the broader market due to ‘panic selling’ when markets plunge. Consequently, it is reasonable to conclude that investors might be unwilling to allocate capital towards such automated trading platforms due to the possibility of a wipe out in the event of a similar ‘black swan’ occurrence such as the ongoing economic crisis.

However, this generalization is not entirely warranted. According to Bloomberg, TD Ameritrade saw new-account openings for its automated investing platform jump 150% between Feb. 19 and March. 30 as compared to the same period a year ago. Wealthfront investment stated that account signups were about 68% higher since stocks declined, while Betterment’s first-quarter account growth was 25% higher than a year ago [1].

The unexpected enhanced interest in robo investment platforms through the uncertain economic climate, can be attributed to several factors. Customer-friendly industry trends such as management fee compression and low investment account minimums, coupled with sharp swings in security prices, incentivized several investors, including young and first time-traders to step off the sidelines. Moreover, the added convenience factor provided by robo platforms to act as one-stop service mechanisms for an array of services such as cash accounts, financial advisory, lending and retirement services has helped develop traction among millennials and Generation X. The ease of opening accounts with robo advisors, setting up ongoing funding contributions, and instantaneously receiving a personalized investment profile after gauging one’s risk and tolerance goals through a few simple questions, are all factors notably fostering growth in this sector. With the spike in national unemployment and work from home restrictions on all non-essential workers, several individuals have experienced increased freedom, spare time and minimal supervision, which has also contributed to elevated trading volumes experienced by brokerages and automated platforms [2]. Lastly, the growth of ‘Thematic Investing’ and Socially Responsible Investing Portfolio (SRI) offerings by robo advisory programs has stimulated interest in their services. These positive trends are expected to sustainably continue, enabling the robo-advisory industry to grow from $600B to $2T in assets over the next two years [3].

Upon closely analyzing the investment returns of the prominent robo-advisors in the industry, it is noteworthy that ~30% of the platforms were successful in outperforming the broader market index. The following section aims to highlight the advisors that exceled and discuss the common attributes that help differentiate them from the industry laggards.

[1] Rockeman, Olivia. Robo Advisors Gain New, Younger Clients Amid Market Turmoil. Bloomberg, 30 Mar. 2020.
[2] Osipovich, Alexander, and Caitlin McCabe. “Coronavirus Turmoil, Free Trades Draw Newbies Into Stock Market.” The Wall Street Journal, Dow Jones & Company, 29 Apr. 2020.
[3] McCann, Bailey. “Robo Advisers Keep Adding On Services.” The Wall Street Journal, Dow Jones & Company, 9 Mar. 2020.

Investment Performance Q1 2020*

Although robo-advisors are conventionally expected to replicate the returns of a broader market index, and not deliver outsized returns or downside exposure, there are several notable exceptions. As illustrated by the data above, the top 5 robo-platforms were able to outperform the Vanguard 60/40 fund, a widely accepted performance benchmark in the industry. Moreover, the standard deviation and range of the data set depict that the individual performance numbers, net of fees, are fairly spread out.

The Wealthsimple portfolio’s success is attributed to its underlying asset selection strategy. The fixed income holdings of the portfolio are exclusively investment-grade, with approximately two-thirds allocated to long-duration U.S. Treasury bonds. In terms of equity securities, its international minimum volatility fund holdings had an inverse impact on returns during the market selloff. SigFig, a long-term top performer, has benefited from a higher composition of domestic large cap stocks than its competitors and a larger allocation towards emerging markets in the international arena. SigFig charges low management fees ($0 on an investor’s first $10,000 managed) which also bolstered returns.

On the other hand, Schwab’s underperformance is primarily a result of its high cash allocation and inclination towards value stocks, which have notably lagged their growth stock peers. Axos Invest managed to limit its losses by actively executing rebalancing trades to unload fixed income and build on its equity positions as the market began to plummet. Wells Fargo’s poor returns are a result of its fixed income exposure in high yield and emerging market ETFs, both of which were hit hard as investors fled to quality assets. Although the fixed income assets of the Morgan Stanley portfolio performed well through Q1 2020, its equity positions lost 28.34%. The fund held an ETF allocated to energy holdings which were particularly hard hit due to lagging demand and political issues resulting in oversupply [4].

[4] “The Robo Report First Quarter 2020.” Backend Benchmarking, www.backendbenchmarking.com/the-robo-report/

Robo Advisors vs. Traditional Research Analysts

An extensive study conducted by professors at The Indiana University Kelley School of Business compared the investment recommendations of Robo-Analysts to Human Research Analysts and inferred several advantages enjoyed by the former. Robo advisors are less susceptible to “behavioral, cognitive or incentive-driven biases”, and revise their investment recommendations more often than traditional analysts. Moreover, buy recommendations by robo-advisors generate abnormal returns (annualized returns range from 6.4 percent to 6.9 percent) that are higher than those generated by traditional analysts (annualized returns range from 1.2 percent to 1.7 percent)[1]. Lastly, the “goal-driven” investment strategy of robo advisors fixates investment philosophy and trading frequency on desired risk-return metrics. Hence, robo advisors are more likely to steer clear of ‘panic selling’ during market shocks and instead stay the course in a disciplined fashion and ultimately reap higher adjusted returns in the long term.

 [5] Coleman, Braiden and Merkley, Kenneth J. and Pacelli, Joseph, Man versus Machine: A Comparison of Robo-Analyst and Traditional Research Analyst Investment Recommendations (February 2020)

Next Steps - Outlook & Preparing for The Future

  • Firms must recognize the growing interest in automated investing platforms and acknowledge the trend in migration of investor preferences from active to passive investment strategies.
  • In order to stay competitive and actively support customer needs, firms should evaluate the costs and benefits of offering robo-advisory investment services. Furthermore, they must analyze whether developing a robo-advisory platform or partnering with an existing firm is the ideal strategic path forward.
  • Financial institutions should consider an array of factors while evaluating robo-advisors for partnership. These include but are not limited to annualized returns over longer horizons, assets under management, number of active clients, management fees and auxiliary service offerings.
  • Firms must also strategically determine a methodology to position their robo-advisor offering against their existing offerings, and effectively manage referrals to other channels as their clients’ robo-advisor account and overall wealth accumulate investable assets.
  • A major downside of robo-advisors during similar market downturns is the lack of personal human interaction to help calm investor nerves and provide effective guidance and counsel. Robo advisors should consider integrating live chat capabilities or video conferencing to human advisors to help bridge the gap and increase the quality and frequency of electronic communication with clients, particularly during market selloffs.
  • Robo advisors should continue to innovate and expand their service offerings to account for the economic backdrop of high unemployment, liquidity issues, and credit defaults. Such firms could consider providing clients with new tools to help save for future emergency expenses and important life events. Moreover, firms could offer free sessions with registered financial advisors to help bolster the lacking human aspect, and help clients develop a renewed plan to meet their financial obligations.

Robo Advisory & Sia Partners

Sia Partners has expertise in Wealth Management and Robo-advisor offerings, with proven execution of large-scale program and platform implementations. Our firm has credentials providing several value-added services to clients in the following areas:

  • Provide strategic assessment to client on the state of the robo-advisor market and future industry outlook, including considerations of existing and anticipated regulations
  • Comparison of pure online vs. hybrid robo models, players, offerings, investment options, account types and service models
  • Determine if a robo-advisor opportunity exists for the client and which segments of its customer base would be suitable to target/serve
  • Determine opportunity to acquire new customers with a robo offering
  • Assess strategies for integrating robo capabilities with existing personal advisor offerings
  • Answer key questions around the role of the robo advisor, integration with existing business lines and advisor models
  • Evaluate short-term solution for robo advisor: partner or buy
  • Align on short-term and long-term robo and virtual advisory strategy
  • Develop initial business case and economic models for both robo and virtual advisory

Your contacts

BHARAT SAWHNEY
Partner Wealth & Asset Management Practice
314-749-5755
bharat.sawhney@sia-partners.com

MATTHEW YEE
Managing Director Wealth & Asset Management Practice
914-320-4039
matthew.yee@sia-partners.com

THOMAS CONOVER
Supervising Senior Consultant Wealth & Asset Management Practice
908-612-1390
thomas.conover@sia-partners.com

RISHIN SHAH
Consultant Capital Markets Practice
516-423-0166
rishin.shah@sia-partners.com

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