History has taught us that it is very difficult for investment managers to outperform the market over a long time frame. Those select few who have are fêted for their brilliance. The recognition of this fact, along with the growing awareness by investors of the impact of fees on their returns, has led many investors to turn to ETFs.
Traditional market cap weighted index ETFs allow investors to track the market at low cost, yet a recent study, ‘Abusing ETFs’1, suggests that investors in these funds still manage to underperform the market because investors cannot resist becoming the discretionary investment managers they shunned in the first place.
The study looked at a sample of investment activity focusing on what product the investors were selecting and the trading pattern of investors. From a product perspective, the study sought to identify whether the ETFs being selected by investors tracked broad or narrow indices. Trading pattern analysis looked at whether investors were investing steadily in their chosen products or whether they were erratically trading in and out of investments. The findings identified that the primary cause of market underperformance was poor trading patterns. The secondary cause was investors selecting indices that were too narrow compared to broader market indices.
Why do investors keep doing this to themselves? To answer this question we can learn much from behavioural psychology studies. Terrance Odean and Brad Barber wrote a paper, ‘Trading is Hazardous to Your Wealth’2, which identified that individual investors who traded most actively had the poorest results while investors who traded the least had the highest returns. They identified that active investors like to lock in their gains by selling stocks which had performed positively but conversely tended to hang onto loss-making positions hoping for a recovery. In addition they identified that individual investors tended to focus their activity on whatever was in the news (recent coverage of bitcoin being a case in point).
Daniel Kahneman and Amos Tversky’s ground-breaking paper, ‘Choices, Values and Frames’3, identified how humans have a very strong emotional reaction to ‘sure gains’ and ‘sure losses’. They gave respondents a pair of questions and asked them to study both before responding. Decision (i) was to choose between:
A. Sure gain of USD240
B. 25 per cent chance to gain USD1,000 and a 75 per cent chance to gain nothing
Decision (ii) was to choose between:
C. Sure loss of USD750
D. 75 per cent chance to lose USD1,000 and 25 per cent chance to lose nothing
They found that 73 per cent of respondents chose the combination A and D, compared to 3 per cent who favoured the combination of B and C. They surmised that respondents wanted to lock in a sure gain for decision (i) but emotionally favoured to gamble on not losing in decision (ii).
In reality the combined outcome of these set pairs was:
A and D: 25 per cent chance to win USD240 and a 75 per cent chance to lose USD760
B and C: 25 per cent chance to win USD250 and a 75 per cent chance to lose USD750
As you can see, the combination of options B and C is actually more favourable but investors’ inability to rationalise unless presented clearly means they are likely to continue to make sub-optimal investment decisions in the absence of a ‘helping hand’.
What will be interesting to see is whether this growth in robo services will result in better decision-making and better investment returns for investors
Which brings us to robo advisers. Robo advisers are software solutions which, following the completion of a detailed questionnaire by an investor, can automatically select investments and build a diversified portfolio based on your preferred investments, risk appetite and financial goals. Once your funds are invested, the software can automatically make changes on an ongoing basis – either to align your investment portfolio back to a target sector allocation or, alternatively, a more discretionary model allowing the robo adviser to allocate capital as it sees fit within expected risk parameters. The intellectual capital underpinning these investment allocations can also vary. Some robo advisers have an investment management committee while others rely on sophisticated algorithms. These products are packaged in easy-to-use applications which can be accessed by investors from their phone, tablet or computer.
Robo advisers may play an important role in helping to negate the decision-making errors described earlier. Assuming a willingness of investors to trust automated investment reallocations, robo advisers have the potential to significantly remove human emotions and biases from investment decisions. That said, there is ultimately still a reliance on either a human investment management committee and/or the skill of the programmers creating the algorithms underpinning robo advisers to accurately analyse risk and reward on a purely empirical basis.
The cost of using robo advisers is typically dependent on the amount being invested and the level of ‘human touch’ sought by investors. Fees tend to be significantly lower than the level of fees expected with a traditional investor adviser relationship but they shouldn’t necessarily be considered a replacement for such an arrangement. They are more likely to be used by investors as a supplementary tool to an existing adviser relationship. Along with being cost-competitive, fees for this service are typically very transparent – ordinarily a fixed basis point fee of the amount invested with no separate costs for additional investment/divestment and, crucially, no charge for portfolio reallocations. This last feature is very important as transaction costs, particularly where there is frequent trading, have been proven to have had a material impact on investors’ returns.
Using robo advisers could also result in improved financial literacy for retail investors, by encouraging them to have a higher-level of self-direction with their portfolios and increased awareness of financial products. Utilisation of robo advisers by retail investors in Europe, to date, has been low but providers such as Nutmeg and Scalable Capital are starting to see traction with investors. This trend will likely only accelerate as technologically reliant millennials’ wallet increases but also as people become more familiar with robo adviser platforms and the funds they invest into. As for older generations, they will probably need a human hand to help them embrace this technology. A recent report4 estimates that demand for hybrid robo services (combining human advisory services with a robo offering) will grow to a size of USD3.7 trillion assets worldwide by 2020 and by 2025 the total market size will further increase to USD16.3 trillion, constituting just over 10 per cent of the total investable wealth in 2025.
In comparison, the same report estimates that ‘pure’ robo advisers (completely automated without personal service added on) will have a market share of 1.6 per cent of the total global wealth at that stage. What will be interesting to see is whether this growth in robo services will, along with transparent lower fees, result in better decision-making and better investment returns for investors.
1Bhattacharya, Utpal and Loos, Benjamin and Meyer, Steffen and Hackethal, Andreas, ‘Abusing ETFs’ (July 11, 2016)
2Barbar and Odean, ‘Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors’, Journal of Finance 55 (2002): 773-806
3American Psychologist, vol 34, 1984, ‘Choices, Values and Frames’
4Business Insider, 21 November 2017: Robo Advisors vs. Human Financial Advisors: Why Not Both?