The debate is on: active versus passive investment management. Most robo advisors follow a passively managed index fund investment approach. Yet, recent market volatility might attract interest in active management robo advisors that strive to…
The debate is on: active versus passive investment management.
Most robo advisors follow a passively managed index fund investment approach. Yet, recent market volatility might attract interest in active management robo advisors that strive to circumvent market declines.
During just two days in October, the Dow Jones industrial average lost nearly 1,400 points or 5.2 percent. The S&P 500 dropped 57.31 points, or 2.1 percent, on Oct. 11. For passive index fund investors, that’s a tough pill to swallow. Yet, active managers attempt to soften the blow of declining investment prices and beat index market returns.
More robo advisors are deviating from passive index fund investing to add in active management components. But is active management better than a strictly passive strategy?
Abundant research substantiates the difficult task for active managers to beat the indexers. A Standard & Poor’s 2017 study found that most actively managed funds failed to beat the market indexes by a wide margin. Yet, as market volatility surges, the search for a salve for losses might make active investing more attractive. And, actively managed robo advisors have stepped in to offer their solution, with management fees below those of the average human financial advisor.
Roi Tavor, co-founder and CEO at Nummo in Zurich, Switzerland, put the decision of active versus passive investing simply: “First, how much are the total costs? Second, what does one get for that price?”
He reminds investors that the largest investment firms, such as BlackRock (ticker: BLK) and Deutsche Bank ( DB) have experienced major outflows from actively managed funds into passive investment vehicles.
So, Tavor advises investors to think before mindlessly choosing one path or another. In fact, many human and robo advisors use a passive first approach with add on active management strategies.
Before we dive into the nuts and bolts of active versus passive robo advisors, it’s important to understand that active robo advisors don’t practice a uniform strategy. “Actively managed can mean a number of things — some positive, some negative,” says Mark Wilson, president at Mile Wealth Management in Irvine, California.
Wilson cautions against going in and out of various markets as “the market timing Hall of Fame is empty.” Yet, if investors desire an active approach, he suggests going hybrid, with a robo advisor that employs some passive index fund investing in addition to a pinch of active strategies. Actually, many of the active robo advisors use this approach.
The pool of hybrid and active management robo advisors is overflowing, demonstrating the demand from investors to temper volatility and possibly beat market returns.
For instance, Qplum, a robo advisor started by two hedge fund veterans, uses index exchange-traded funds in one of its active approaches and adjusts the asset allocation based upon market conditions. Regardless of the active strategy, Qplum charges a 0.50 percent fee, or $50 annually for every $10,000 invested.
Alpha Architect and Bank of America’s Merrill Edge Guided Investing both strive to beat the market with automated robo advisor computerized investing and human guidance. The passive plus active investment elements attempt to supplement the 100 percent automated investment approach. Merrill Edge charges a management fee of 0.45 percent.
Another actively managed robo advisor is T. Rowe Price’s ActivePlus Portfolios. This robo advisor repurposes existing actively managed funds for their robo advisory clientele. The platform offers eight to 13 proprietary actively managed funds. After the typical goal and risk questionnaire, the digital investment manager creates the ideal portfolio and rebalances it when needed. The fees for this strategy vary based on the percentage of each fund in your account, ranging from 0.55 to 0.81 percent.
Kalen Holliday, media communications director at Interactive Brokers Asset Management (formerly Covestor) in New York, believes investors should have a choice. Young and new investors are well served by a traditional low fee passive robo advisor who helps them begin investing regularly, Holliday says. Sophisticated investors might benefit from a customized strategy with an experienced human financial advisor who attends to tax issues and specialized circumstances.
Interactive Brokers is like a clearinghouse for investors seeking various asset management styles. They offer several robo advisor passive portfolios and actively managed options with various fund managers for a range of fees from 0.08 to 1.5 percent. This smorgasbord of investment options offers something for every type of passive and/or active investor.
Benjamin Halliburton, chief investment officer at Building Benjamins robo advisor in Summit, New Jersey, also touts the hybrid passive and active approach. He believes there are areas of the market where active investment can add value and includes those in the Building Benjamins robo advisor.
“Active allocation to diversifying assets like real estate, reinsurance, infrastructure, alternative lending, timberland and variance risk premium capture is the wisest way to improve the expected risk adjusted return profile,” Halliburton says. His rule of thumb is use passive funds in efficient corners of the market and extract value from less efficient sectors such as emerging markets and small-cap holdings. The management fee is 0.45 percent.
The pros and cons of actively managed robo advisors versus the passive index fund approach depend on the goals of the investor.
For investors that are content with market-matching returns and can accept the volatility of their chosen asset allocation, a low-fee passive robo advisor will fit the bill nicely. Between 1928 and 2017, the S&P 500 index returned an annualized 9.65 percent. During that same period owners of the 10-year U.S. Treasury bond realized 4.88 percent annual returns. It’s safe to say that index fund owners would have enjoyed similar returns less small management fees, had they invested in those popular asset classes, either on their own or with a robo advisor.
The disadvantage of passive robo advisors is that you won’t beat the markets.
Of course, prior returns don’t guarantee future investment performance.
The advantage of an actively managed robo advisor is that you have the opportunity of outperforming the passive index fund approach with lower risk. And, an actively managed robo advisor will typically charge lower fees than those of the higher priced human financial planner.
The disadvantages of actively managed robo advisors relative to their passive index counterparts is embedded in the active management issues in general. Active management tends to result in higher costs and less diversified portfolios, says Paul Ruedi Jr., financial advisor at Ruedi Wealth Management in Plano, Texas.
Should you invest with an active robo advisor? The answer depends on your preferences. Analyze your personal situation and decide if you want to attempt to beat the market and reduce volatility with an active approach.
As robo advisors are relatively new entrants in the financial advisory sphere and markets have been on a tear for 10 years, there’s a paucity of reliable investment performance data for the active robo advisor. So, proceed with caution and consider trying the active robo with a portion of your investment dollars, not the whole amount.