Robo-Advisors are emerging as favorites for millennials due to their generally low account minimums, low fees and efficient structure.
Diversification, ETFs, Mutual Funds… We’re assuming that these terms are not your cup of tea?
Investing efficiently is surely no easy task. It may seem daunting to inexperienced investors with all that financial jargon flying around.
The fact of the matter is that saving and investing at a young age can prove to be a huge advantage, and robo-advisors (RA’s) are here to help with exactly that.
What is a robo-advisor?
RA’s are simply automated, financial advisors. The online tools act as a financial advisor would in picking an optimal investment portfolio for you.
Most of them start by asking you a few questions to understand your risk appetite and allocate your investments accordingly based on certain algorithms. Once you agree to your allocation, you fund your account and the RA will go from advice to action, buying the securities for you and managing your portfolio by rebalancing it periodically. It’s that simple for you as a client.
One thing you may not know is that there has been extensive research on measuring an individual’s risk tolerance, as studies show that one may overestimate the amount of risk they are willing to take to meet return objectives. Many RA’s have designed processes around that concept by asking few, but carefully designed questions with a specific scoring method.
The logic behind the methodology
The general concept is that typically, a more aggressive portfolio would have a larger allocation to stocks and may experience larger short-term swings compared to a conservative portfolio, which would have a larger allocation to fixed income investments.
The hypothetical example below is like an excerpt you’d see in ‘Risk Tolerance for Dummies’. It’s broken down to the very basics.
“Let’s take a look at Mr. Smith, a 60-year-old farmer who’s retiring soon, and Mrs. Green, who’s a 30-year-old lawyer. Since Mr. Smith is likely to retire soon, he’d want to protect his wealth and will be happy with a modest gain. After all, he’s going to live the rest of his life mostly off of his savings. Mrs. Green on the other hand is further away from retirement, and will more likely tolerate a few swings in her portfolio for the possibility of larger returns after 30 years. She has some time to cover up for losses.”
To understand how most robo-advisors invest, we’ll quickly explain passive and active investing, highlighting the main difference between the two. We’ll then clarify what exchange traded funds are.
Passive and Active Investing
First let’s explain the difference between active and passive management.
An active investor is someone who tries to ‘buy low and sell high’ several times to make a profit. It’s not easy. In fact, it can be more difficult than trying to guess the plot of the next Game of Thrones episode.
A passive investor on the other hand creates an ‘optimal’ allocation and sticks with it. The passive manager believes that timing the market may generate returns in the short term, but overall the active manager will underperform a passive one due to the sheer difficulty of timing the market.
A paper by ‘Benke and Ferri 2013’ showed that a passive manager outperforms a comparable active manager 82% of the time! (Between 1997 and 2012)
Many robo-advisors therefore implement a passive investing approach. The fees paid to passive managers are considerably less than the ones paid to active ones, which can be quite attractive to clients.
Exchange-Traded Funds: How Robo-Advisors Invest
The concept is very simple. Exchange Traded Funds (ETF’s) are a group of stocks or securities. It’s like grouping GM, VW, Ford, and Fiat-Chrysler all in one fund, and then buying shares in the fund instead of buying shares in each company separately.
These funds are called exchange-traded funds, simply because, they are traded on an exchange. So you can buy shares in these funds just like you would buy normal stocks.
To highlight the benefit of ETF’s, take a look at the graph below. It shows the returns of Netflix, Twitter, and a tech sector ETF assuming an initial investment of $100 from March 2015 to March 2017.
Source: Yahoo! Finance
This chart was intended for illustrative purposes only. Past performance is not a guarantee of future results. All investments includes some risk, including the possibility of loss of principal.
Someone who invested in Twitter two years ago would have lost more than half of their money, whereas someone who invested in Netflix would have more than doubled their money. The ETF returned almost 30% in two years. The volatilities are crystal clear and it shows how brutal stock picking is.
Robo-advisors want to ensure a smooth and profitable ride for the client with a lower probability of losing money. Therefore, robo-advisors primarily invest in ETF’s.
New Diversification Options with New Robo-Advisors
In addition to stability, diversification is key when investing, not only through different stocks but across different asset classes as well. Robo-advisors’ passive investment strategies are built around that concept.
For example, an ETF tracking small tech companies that are trying to change the world will be more volatile than an ETF tracking the largest utility companies. The different weightings assigned to each ETF are the bread and butter of robo-advisor allocation models.
More importantly, fixed income investments play an extremely vital part in portfolio diversification due to their low correlation with stocks. Halal bonds, which are known as Sukuks or Islamic bonds have typically been inaccessible by retail investors as they’re sometimes traded in blocks of $200,000. Moreover, most Sukuk owners hold on to their bonds till maturity, thereby limiting the growth of a secondary market where Sukuks can be traded.
One advantage of using Wahed as your robo-advisor is access to this crucial asset class. In addition to enjoying lower fees with Wahed, the Sukuk fund Wahed is working with has agreed to waive certain expenses for our clients!
We’re always finding new ways to revolutionize financial services at the intersection of robo-advising and Halal investing.
Open up your first account with an Ethical robo-advisor in minutes on Wahed today!