Can Robo-Advisors Hold Up In A Downturn?

Robo-advisors have been around for several years now offering affordable online investing services with an element of human advice. In general, investors who use a robo-advisor get assigned to a pre-packaged portfolio of low-cost exchange-traded funds (ETFs) based on their risk tolerance. Portfolios are regularly monitored and re-balanced whenever a client’s asset allocation drifts away from its original target.

The arrival of these digital platforms coincided with a period of strong stock market returns and new clients were keen to join the robo-advisor revolution. Fledgling start-ups like Wealthsimple, Nest Wealth, and others were quickly joined by big bank offerings such as BMO SmartFolio and RBC Invest Ease.

How will robo-advisors hold up in a market downturn?

There’s an old adage that “a rising tide lifts all boats” and so while clients might have been thrilled with healthy returns and lower fees over the past few years, it’s fair to wonder how robo-advisors, and their clients, will hold up during a market downturn.

Indeed, the stock market decline last quarter had many investors fearing a prolonged downturn or a crash. When that happens, says Randy Cass, founder of Nest Wealth, investors start looking for something better elsewhere.

“Investors who use a digital advisor are no different than investors who use a traditional advisor,” says Cass, who adds that the timing of investors changing advisors or switching platforms is highly correlated with negative market performance.

Millennial investors, many of whom have never seen a bear market in their investing lifetime, may be particularly vulnerable to irrational behaviour during volatile markets.

This type of investor might be logging into his or her account more frequently when stock markets are down. Robo-advisors leverage technology to identify nervous investors who fall into a category of behaviour deemed to be ‘abnormal’ and then present messaging to them online or via email reminding the investor of their long-term time horizon and risk tolerance.

“We’ll remind clients that during the on-boarding process we said this type of portfolio might see drawdowns of 10 per cent or more in the short term and that this market volatility is perfectly normal,” says Cass.

Most robo-advisors operate under the philosophy that it’s better to build a diversified portfolio that tracks the global markets for a small fee rather than try to beat the market through active management (stock picking and market timing), which tends to cost more.

That means the type of investor attracted to a robo-advisor knows they can’t control what markets do in any given month, quarter, or year, and should be prepared to accept whatever the market delivers.

It’s that philosophy that has Dan Tersigni, a portfolio manager at Wealthsimple, thinking that digital services are actually really well-positioned to guide clients through market volatility.

“We’ve set a different expectation than a lot of the industry does — outperforming the market is not part of our value proposition,” says Tergigni.

Instead their promise to clients is to set them up with a diversified portfolio designed to meet their goals, be transparent, and keep fees low.

“We can’t control the market, and neither can they, but we can help keep them on track and informed,” he says.

Meanwhile, traditional financial advisors have been under pressure to offer more than just their stock picking prowess. Low cost index investing solutions (like robo-advisors) have commoditized investment advice, but the value of human advice has always been psychological – helping clients stick to their plan during turbulent times and preventing a panic induced mistake.

There’s a perception that robo-advisors don’t have the human communication capability of a traditional advisor. But robo-advisors can get a message out to their clients much more quickly than a traditional advisor through their product platform and via email and text message.

“When something unusual happens in the market, all our clients have a message from us within hours explaining what’s happened in simple, human terms and encouraging them to stay calm and stick to plan,” says Tergigni.

Interestingly, clients receive similar messaging in good times and bad. When markets were seeing record highs, Wealthsimple sent a message to its clients telling them not to rely on it or to chase bigger returns.

While it’s true that robo-advisors remain untested in a prolonged bear market, by leveraging technology with behavioural psychology they can quickly calm nervous investors and prevent panic.