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Wednesday, September 9, 2015

Does that Higher Advisor Fee from the Human Always Mean Worse Returns than The Super Low Fee "Robot"....Do More Advisor Assets Management Cause Lower Potential Returns ?

I am a big believer that investors should keep a sharp eye out for the costs related to their investments. That is the reason I recommend portfolios composed of low cost ETFs.

But a closer look shows that this claims by robo advisors about the improved investment results because of their low fees may not actually be accurate upon closer inspection. Here is how Wealthfront presents its comparison to an advisor charging 1%
They estimate that a wealthfront advisor would benefit from the full impact of the difference between and advisors 1% fee and their fee of .25% every year over the life of the clients account.

 Betterment makes a similar claim calculating an investors savings of  over $55,000 on a $100,000 initial investment over 20 years.

Those claims are extremely simplistic and the market activity of the last few weeks is a case study in why.

Execution matters

The always insightful Jason Zweig of the WSJ  Presented some basic rules for readjusting portfolios and trading. These are particularly important in the volatile markets we are seeing as of late:
 trade seldom — but, when you do, trade smart. Check in advance to see how late in the day you can buy a mutual fund and still get that day’s price. Avoid buying individual stocks or exchange-traded funds during the first hour (9:30 to 10:30 a.m. Eastern time) or last half hour (3:30 to 4 p.m.) of trading, when prices can be especially prone to big swings.
And always use “limit orders” stipulating the highest price at which you will buy (or the lowest at which you would sell
If you have an advisor ask about his trade execution.
Unfortunately simply using an advisor doesn’t guarantee proper execution as the article notes:
On Aug. 24, the day the Dow dropped 1,000 points, it materialized that some financial advisers don’t use limit orders when trading ETFs. There are still a lot of advisers who built their practice on mutual funds and have never really been through the wringer on trading ETFs,” says Dave Nadig, director of exchange-traded funds at FactSet. “This volatile market is unforgiving for people who don’t know what they’re doing” — and their clients.
 Those who ran into trouble would be those who had orders in place to sell an ETF that fell by a certain percentage. Such orders may have been executed at a price much lower than even where the order kicked in as shares fell quickly, he says.
TDAmeritrade Institutional, TDAmeritrade Inc.’s unit supporting independent registered investment advisers, said it has heard from some advisers who had ETF stop orders execute at the market open Monday. Advisers were not asking for the firm to reverse trades and the firm has no plans to do so at this time, a spokeswoman said in an email.
“Advisors we’re hearing from understand our responsibility is to make sure the mechanics of the stop-loss orders work as they are designed, which they did,” she said in the email. “Once a stop order is triggered, the order is turned into a market order to trade at the next available price. Extraordinary market volatility at the open played a huge part in pricing swings of some ETFS.”
Not surprisingly Zweig advises
So, if you use an adviser, make sure he always uses limit orders when trading ETFs. He can’t bottom-fish for you if he doesn’t know how to use the equipment.
In fact in many cases you don’t even have to ask your advisor. Many advisor managed accounts are separately managed for each account and you should be able to see the details of your trade executions in the information your broker provides
About Execution by Those Robo Advisors
The trade execution at a robo advisor is not at all transparent. It is impossible to know what time of day the trades are executed and how they are entered are they market orders or limit orders. How often does the account trade. We already know that Betterment proudly declares that it trades on a daily basis for “optimal tax management”. But does all that tax management trading actually increase the performance of the portfolio pre and after tax ?
If Jason Zweig recommends trading seldom what happens to a wealthfront portfolio when as they themselves state part of their strategy is to trade as frequently as daily or even several times a day.
Critics of actively traded mutual funds have pointed out the potential costs of market impact the slippage between the market price when a mutual fund begins to execute a trade and the final price of its transaction. A large trade “moves the market against the trader” as the price moves up as the large investor executes its buys (or the opposite for sells)
Most robo advisors trade ETFs but Wealthfront with its strategy executes trades in hundreds if not thousands of individual stocks increases the potential for market impact. John Bogle the pioneer of index funds estimates the cost of market impact at .50% 

With robo advisors growing rapidly in assets –Wealthfront is already over $2 billion the potential costs due to market impact is extremely high…and remember Wealthfront is trading stocks not ETFs.

The more assets in the investment advisory firm the more likely for unseen costs because of execution. Investment firms are required to enter trades as block orders” all accounts buying or selling a security must have their trades aggregated in an order. The larger the assets the greater the potential for market impact or for the trades executed in a mechanical manner.all trades entered at a particular time of day regardless of market conditions for example.
A smaller more sophisticated advisor might be able to “fine tune” the execution to take account of trading and market conditions.

The real question to ask about the “cost” of those higher fees or perhaps more accurately in the case of robo advisors the cost of those lower fees and automated activity.

All of the calculations and assumptions and marketing material related to robo (and probably many other advisors) are based on the portfolios performing exactly as the underlying indices and ETFs performed…based on closing prices.
But in reality there is absolutely no guarantee of that …and probably no way to even check .certainly not with a robo advisor and with extreme difficulty if at all with other investment advisors.
The hidden costs of execution particularly when comparing a large robo advisor executing trades in the $100s of millions compared to an advisor that executes taking into account trading technigwues an advisor that in Zweig’s terminology “knows how to use the equipment”.

What if you do it yourself ?
Many individuals choose to manage their portfolios on their own often persuaded by the argument that if an advisor “just manages a stable allocation of ETFs” the fee is a needless cost.
Zweig notes some important guidelines for executing transactions such as not trading in the first or last hour of trading and using limit orders. There are many other techniques involved in improving execution. Do many investors have the time and skill to execute their transactions in the optimal manner ?

The difference in performance because of execution can easily exceed advisor fees, not to mention added value through rebalancing and tax management. While there is no reason not to expect a full range of services from your investment advisor..proper execution alone is an important factor.

1 comment:

Jess Shpek said...

Great recommendations for the investors! Thank you! I`m working at the investment company and we often consult to get an expert advice in this sphere.