Robo-advisors are automated programs providing online wealth management recommendations—absent the assistance of actual wealth managers. These innovative programs rely upon established investment advisory convention to build algorithmic outputs that promise wider application at far lower cost than current investment advisory fees. According to Deloitte Consulting, robo-advisory, while largely confined to the younger, typically less affluent Gen X and Y cohorts, had increased by 65 percent to $20 billion in assets managed as of year-end 2014. Deloitte predicts this model will reach $5 to $7 trillion in assets over the next decade!

 “Hybrid” advisory combines the robo algorithmic outputs with an actual investment advisor’s planning input—but at a higher fee. We liken this model to mass customization (mass production of planning services with some flexibility or personal touch). This concept is not new in the asset management space where client customization has purposely been avoided with products like mutual funds. However, in the investment advisory space, where customization should be the norm, robo advisory and even the hybrid robo variety should be considered fundamentally different approaches.

Because most advisors are compensated by fees based on assets under management, successful advisors have focused their businesses on the more affluent high-net-worth (HNW) clients—those with $1 million or more in portfolio assets. HNW investors have complex, often unique tax, estate and financial planning needs and these require knowledgeable professionals and quality advice that may not be necessary with the less affluent.

Technology And Disruption

While investment advisory has been criticized as an industry rife with self-interest, excessive cost and a lack of differentiation, the prospect of the industry being “uberized” by clever software engineers is chilling. That every segment of the service sector is at similar risk is hard to argue; but on-demand investment advisory? And you can be sure that the more affluent boomer generation will be targeted as enhancements to existing robo programs evolve.   

The 100 basis point question is…will acceptance of robo models fundamentally change or disrupt the investment advisory industry? We believe that the threat is real and over time the industry will see change—especially for those with simpler needs. However, there is a solution. To avoid the probable disruption associated with wider acceptance of algorithmic advisory programs, professional advisors should embrace the individuality that makes each client’s plan unique. This higher level of customization will provide a more in-depth and tailored solution that offers greater value. 

Though well-designed and marketed, robo-advisory algorithms are currently limited in the number, depth and complexity of the queries used to generate the output. Further, these solutions are largely focused upon developing on-demand asset allocation with a few well-diversified investments (typically ETFs). And while the hybrid robo model provides some access to financial professionals, these solutions are not designed to offer individualized asset location management planning, tax-aware best practices, retirement transition planning or estate planning. Equally important, it is not clear that robo on-demand advice is iterative or able to reflect the changing objectives and constraints common among transitioning retirees.

My Advisor Is An Android?

Just as Lieutenant Commander Data, the famous 25^th century android played by Brent Spiner on the TV series Star Trek, struggles with his lack of humanity and inability to recognize basic human emotions, so too, do robo-advisors lack the ability to empathize or understand the rudimentary tenants of the human condition. Data's sophisticated, futuristic systems and programming are simply no match for the subjective complexities attendant to human interaction. In short, FAs have a distinct edge over robo advisory as they can recognize the subtle nuances essential in providing clients with high-value solutions. Besides, few would consider robo-advisory a braggart’s status symbol—or worthy cocktail party fodder.

Lower Returns

During the 2009-14 bull market, returns averaged an impressive 17 percent annually (S&P 500). But as we approach the end of this market cycle, fully priced stocks will likely limit future returns. And when combined with dangerously high, yet still-rising federal debt levels, slow GDP growth and abysmal bond yields, poor stock returns could seriously impair retirees’ lifestyles. An extended period of difficult market conditions would compel investors to search for a more cost-effective and/or tax-aware investment solution.

Five Best Practices That Add Value:

I. A Core-Satellite Approach And The Use Of Separately Managed Accounts

Core-satellite is a well-established approach to portfolio construction that offers investors the potential for improved performance. With core investments, where little is to be gained from high turnover, less active, lower cost managers become the focus. Emphasis in core is placed upon tax planning and improved after-tax returns while satellite strategies offer unique investment exposures and the potential for manager value add—but are seldom tax friendly. Through the use of separately managed accounts (SMAs) advisors can treat each security independently and in the most appropriate tax-aware manner for each client. Unlike mutual funds or exchange-traded funds (ETFs), SMAs are a portfolio of independently tradeable securities reported on as a whole. With a core-satellite approach that uses SMAs the asset manager and investment advisor have the ongoing ability to add value by working as a team to support client objectives. This collaboration is not possible with the “one size fits all” robo outputs.

II. Understanding Each Client’s Unique Circumstances

Successful tax-aware investment advisory requires in-depth knowledge of each client’s tax situation, securities restrictions, the basis and holding time-frame of each position, monthly cash flow needs, the strategy and timing for deferred asset drawdowns (401ks and IRAs), pending large scale purchases and other relevant factors. Communication with tax and estate counsel is a must if this knowledge is to be used to its greatest effect. Instead of forcing clients to fit an advisor’s “model” (commonly employed to drive simplicity and scale), advisors must strive to build a customized solution dedicated to each client’s specific objectives and constraints. Robo algorithms are limited in the number and depth of the questions they can ask leaving them unable to properly account for unique individual circumstances.

III. Location, Location, Location

Few would argue that location is an important consideration when analyzing real estate. Likewise, thoughtfully assigning assets a specific account location based upon the tax implications of each specific client is one of the more valuable planning considerations an investment advisor can provide. Many advisors handle all client accounts—deferred or taxable—alike regardless of the tax implications. This lack of asset location planning (especially as it impacts the realization of gains in taxable accounts) can be extremely costly. Robo algorithms are ill equipped to provide the sound asset location management advice that many sophisticated advisors routinely provide.

IV. An After-Tax Approach Using Disciplined Gain/Loss Budgeting

The primary objective of high-net-worth investment management should be to achieve the best possible market returns for a given level of risk while actively postponing the realization of taxable gains and maximizing realized losses (especially the short term variety). Without the security specific granularity provided by SMAs, tax-aware investment management is not possible. With the help of tax counsel, advisors can establish an annual tax budget for each client and thereby better plan necessary transactions while avoiding ugly year-end tax surprises. Taxes alone should never drive important investment decisions, but they ought to be a meaningful part of all planning. Extending holding periods, minimizing portfolio turnover and employing  HIFO tax-lot accounting can support a much improved after-tax outcome. Robo and hybrid robo-advisors typically use low-cost ETFs which may be tax-efficient (passively postpone taxes) but are not tax-aware (actively minimizing taxes).   

V. Ongoing Tax-Loss Harvesting

Tax loss harvesting, the concept of selling securities that fall below their original purchase price or basis, can add extraordinary value to a client’s after-tax spending capacity. Losses can be harvested on an ongoing basis (not just the once-a-year routine reluctantly offered by most SMA managers) as a way of adding value through lowered taxes. As short term gains are taxed at a higher federal rate (39.6 percent) than long-term gains (23.8 percent), seasoned advisors prioritize their harvesting efforts on positions held for less than one year. We recommend loss harvesting of individual securities within a core SMA with suitable quality replacement of the issues sold. With robo or hybrid robo-advisory portfolios, loss harvesting typically requires liquidating a key ETF holding where underlying securities are at both gains and losses. The benefits of this sort of wholesale liquidation are very likely to be lost and the transaction may alter the intended long-term asset allocation.  

The Real Threat Is Commoditized Investment Advice

We are convinced that HNW investors, especially the boomers, will continue to favor knowledgeable, well-trained professionals. Those who are willing to take the time to understand the unique financial objectives and constraints of each client as a way of customizing the right balance of proven practices, tools and systems will ultimately prove the most successful. Investment advice commoditization exists where advisors have gotten away from best practices. In an effort to achieve greater scale, many advisors have developed an over-reliance on automated systems and a one size fits all mentality lacking in collaboration, thoughtful examination or tax-aware best practices. One size cannot and should not fit all. 

Professional investment advisory success should not be defined by achieving short-term superior returns at the cost of diversification or other ill-defined risks. Nor should it be defined by temporary out-performance to a benchmark of questionable application. Successful advisory must solve the financial problems that keep clients awake at night. Not only do those problems vary by client, they also have a habit of changing over time. Whether the goal is sustaining a retiree’s lifestyle, supporting the education of family members, funding adequate insurance and healthcare, charitable gifting or all of the above, each solution must be customized by making the best use of available client resources.

Robo and hybrid robo-advisories will improve over time and likely take market share from both Gen X and Y cohorts—especially those with less complex needs. We believe this will benefit all as these investors will receive a solution that most FAs are ill-suited to provide at similar cost. Unfortunately, this may contribute to advisory fee compression over time. And those converted to robo advisory may decide to remain with the robo solution even as they join the ranks of the HNW. Still, we are convinced that robos do not currently pose a significant disruptive threat to HNW advisors embracing best practices.

Like Commander Data, robo algorithms and digital eyes are no match for human vision, understanding and empathy. Holistic client solutions that embrace best practices including an after-tax approach, core-satellite philosophy employing SMAs, asset location management, gain/loss budgeting and tax-loss harvesting will continue to successfully support HNW investors. 

We believe poorly performing equity markets currently pose a greater risk to investment advisors than disruptive robo advisory models. A decade-long combination of unanticipated events has caused equity markets to become fully valued, while interest rates have fallen to levels that threaten the lifestyles of retired investors. Deflationary pressures, less favorable demographics (as boomers age) and high debt levels present problems that will demand new thoughtful investment solutions and sophisticated investment strategies provided by dedicated investment advisors.   

We would like to recognize our colleague and great friend, Doug Rogers, for his groundbreaking work in the area of tax-aware investment management. Doug passed away in February of 2014.

 

Steve Riley CFA, CFP; and Rick Furmanski, CFA, CFP, are tax-aware portfolio managers at Clearview Wealth Solutions in Lake Zurich, Ill.