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Tuesday, February 6, 2018

Market Volatility is Tough For Robo Advisors to Handle


via Investment News

Robo-adviser websites crashed as market slid

Wealthfront, Betterment websites went down Monday, cutting clients off from accounts

By Bloomberg News   |  February 5, 2018 - 5:47 pm EST
Robo-advisers haven't had much experience with market routs. When confronted with one on Monday, they struggled.
The websites of two of the country's biggest robo-advisers — Wealthfront Inc. and Betterment — crashed as the S&P 500 Index sank 4.1%.
Complaints quickly spread across Reddit and other internet sites from people who had trouble logging onto their accounts. "Really?" wrote @jlpatel23 after he received a message from Wealthfront saying its site was down.
The glitches represent a setback for a niche of the financial market industry that has been booming of late as people have become more comfortable making investment decisions without speaking to human advisers.
Wealthfront acknowledged in a statement that its clients lost access to their accounts for "a short period of time today" and said it's working to ensure that "clients don't experience this again."
Betterment didn't immediately respond to requests for comment. Back in June 2016, during the Brexit fallout, Betterment had told users that it instituted a "short delay in trading" to protect its users from a "potentially erratic market." No such statement was issued by the company in this case.
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This is particularly worrisome not only because a similar glitch occurred during a the last major one daymarket move (7 months ago). But also because it calls into question the actual structure and implementation of the activities of these providers.
These robo advisors are neither platforms for individuals to conduct trading nor are they regulated mutual funds. Thus they don't follow under the same scrutiny. They are registered investment advisors who almost  never implement strategies that involve short term trading. Yet they manage assets in a manner at times potentially more akin to a  a hedge fund with short term trading based on an algorithm..but don't have the same transparency.
They have also grown extremely quickly to assets under management in the area of $10 billion but have minimal experience in executing their market strategies in the financial markets.
The Perils of Tax Loss Harvesting
A key selling point of the robo advisors is that constantly review accounts for "tax loss harvesting opportunities' done on an ongoing even in some cases intraday basis. In order to do this a firm would need to have extremely sophisticated monitoring and trading capabilities Each account would need to be examined for individually (since there would be virtually endless permutations of cost basis and purchase date) and then thousands of buys and sells.
Given that these companies' systems were overwhelmed in simply keeping the client interface up and running it seems doubtful the necessary computer firepower to do that tax loss harvesting would be in place.
Furthermore the tax loss harvesting on a day like yesterday would have likely had little real economic benefit. Over the course of the day for instance there would have been "opportunities" to sell to harvest short term losses in accounts that made purchases in periods since the beginning of 2018, Upon the sale a new purchase of an "equivalent security" would need to be made. 
Later in the trading day security would have dropped furhter with a new "opportunity to tax harvest" with another paired trade. This would have to be executed across a range of ETFs that cover the same asset classes, At the end of the day there could have been 10s if not hundreds of trades across a portfolio composed of 10 or more ETFs in a portfolio from Betterment. 
At the end of all trade trading an investor could be left with a large number of short term capital losses, or a simply a large number of transactions which had the end of the day accomplished nothing as gains offset losses. 
If there were net losses on the accounts it is possible that for a larger investor  the losses would be larger than the $3,000 that is deductible each year. Those losses would be carried over to the next year and based on Betterment's explanation of its strategy it would be equipped to manage harvesting of the losses carried forward to maximize.
Furthermore if the market recovers from the levels at which some of the purchases were made the accounts now hold shares at a lower cost basis and higher potential tax liability than if nothing was done at all.
And then there is the issue of transaction costs. Each time a tax loss harvesting trade is made there is a buy and a sell and thus a spread paid on each trade. These costs on dozens if not hundreds of trades in an account could easily eat into whatever tax benefit might theoretically exist for the strategy. 
There is an additional unseen cost of slippage. The tax loss harvesting strategy is based on executing the two trades without a discrepancy in movement in the market. For example to be done correctly and seamlessly the sale of one total market etf that is down 1% should be offset by another total market etf when it is also down 1% if not there is what is called "slippage" and the strategy has not been optimized.
For Wealthfront the trading challenge is even greater. Their strategy of "direct indexing" means that in place of ETFs in several asset classes it owns individual stocks. And in their "tax loss harvesting" they will execute hundreds is not thousands of trades in an individual portfolio on a day like yesterday. And of course the issues of spreads and slippage are far greater than in the case of Betterment.
The challenges outlined above would be massive for a large well established investment firm with decades of experience creating portfolio management systems and large staffs of professionals with technical and market experience. And even in the case of those firms we have seen major "glitches".
Both Betterment and Wealthfront have grown to around $10 billion each in assets under management in a very short period of time. Their staffing comes almost exclusively from people with not experience in the financial markets and asset management.

Wealthfront and Betterment addressed the outages although Wealthfront did not address issues related to their complex "direct indexing strategy". And of course it is impossible to know what transactions costs or slippage were encountered.
Wealthfront admits in a statement that its clients couldn’t access their accounts, but only for a brief period of time Monday, and that the firm is working on a fix to prevent this sort of outage from happening again, Bloomberg writes.
A Betterment spokesman, meanwhile, tells the news service that the robo’s clients had trouble logging in for around 30 minutes yesterday afternoon, but that account activities such as rebalancing and tax loss harvesting went on uninterrupted. Vanguard’s spokeswoman tells Bloomberg that only “some” of its clients “may have” run into “sporadic difficulty” getting into their accounts online and over the phone. And a Schwab spokeswoman tells the news service its clients had delays logging in for just a few minutes, due to increased demand.





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