Practical Applications of Individualization of Robo-Advice

Michael Faloon and Bernd Scherer

PA 2018, 5 (4) 1-4

doi: https://doi.org/10.3905/pa.5.4.262
http://pa.iijournals.com/content/5/4/1.8
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Practical Applications of

Individualization
of Robo-Advice
Authors: Michael Faloon
Overview
and Bernd Scherer
Automated asset management advisory firms, often called robo- Source: The Journal of Wealth
advisors, assign portfolios to individual investors based on investment Management, Summer 2017,
Vol. 20, No. 1
algorithms. These algorithms use investor characteristics such as
Report Written By: Howard Moore
age, net income, and assessments of individual risk aversion to
Keywords: Asset Allocation, ETFs,
recommend suitable asset allocations. Client interaction and delivery Passive Investing, Robo-Advice
of portfolio advice are web-based and without human interaction.
Robo-advice disintermediates the classical distribution model, which
is now widely recognized as expensive, difficult to scale, and, usually,
dependent on the individual advisor’s skill level. As a result, those
with lower levels of wealth that do not meet minimum account limits
are left stranded with little access to financial planning advice. This is
where the robo-advisor comes in.

In Individualization of Robo-Advice, published in the Summer

2017 issue of The Journal of Wealth Management, Michael Faloon
and Bernd Scherer discuss the pros and cons of robo-advisors,
highlighting their lack of sophistication in allocating assets based on
Asking the right investor
investors’ individual needs. questions is key
✓ Investor objectives
Practical Applications
✓ Risk appetite
• Robo-advisors are a new and exciting development. They have
every potential to establish a new standard in fiduciary client advice ✓ Risk aversion
and become the model of choice for passive investors.
• The quality of robo-advice is difficult to assess. Asset allocation
recommendations seem generic and poorly individualized, and it’s
not clear that they are based on an investor’s household balance
sheet and individual risk aversion.
• Investment options are usually limited to passive strategies.
It has not been determined whether robo-advisors offer a truly
diversified set of risk premiums or just traditional beta.

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Key Definitions
Household balance sheet
A financial statement that
summarizes a household’s, or an
individual’s, assets and liabilities
at a specific point in time to
quantify what is owned and what
is owed.
Passive investing
A strategy that tracks a market-
weighted index or portfolio,
typically through an index fund.
Robo-Advisor
A wealth management service,
available online, that provides
automated portfolio management
advice without the use of
human financial planners. Such
automated systems often
use preprogrammed models
and parameters to assist with
investment decisions. An
investor supplies a profile,
including information on income,
savings, and risk preference.
Based on that information,
automated systems will offer
recommendations, which may be
adjusted as life circumstances
change over time.
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Discussion
“Even before robo-advice, the standard advice you got from a
wealth manager or corporate 401(k) plan was always somewhat
lazy,” says Bernd Scherer, chief investment architect at Deutsche
Asset Management, in Frankfurt. Investment clients differ in so
many ways: wealth, profession, age, gender. All of these factors
affect optimal asset allocation decisions. For decades, the wealth
management industry has been criticized for inadequately providing
individual guidance. “We hoped that robo-advisors, being automated
and seemingly objective, would make up for it by asking better
questions to find out more about the client,” says Michael Faloon,
chief operating officer at Standish Mellon Asset Management in
Boston. But they were disappointed. “The advice I saw was lazy,
unimaginative, and seemed to come from a 1950s-era textbook,”
says Scherer, who points out that many more people who develop
robo-advisories come from an IT background than from a financial
planning or financial economics background.
Two things distinguish one investor from another: level of risk
aversion and household (or individual) balance sheet. The investment
management industry tends to focus on risk aversion in isolation.
“But it doesn’t mean very much in terms of asset allocation,” says
Faloon. An individual may be willing to take risks, but it’s possible
that she recently took out a mortgage to buy a house, for example.
“A mortgage would represent a high degree of risk in that person’s
balance sheet, which might not allow too much additional risk on the
asset side,” he explains. Everyone has a different balance sheet, and
everyone approaches it differently, whether mark-to-market or book
value, for example, which usually drives optimal asset allocation
choices. “It was this concept that motivated us to do the research,”
says Scherer.
Robo-advisors collect the necessary inputs required for their
investment algorithms through web-based questionnaires that users
of their services must answer. The questions fall into three categories:
investment objectives, to decide on asset-only or asset-liability
(such as retirement) optimizations; risk appetite, to determine risk
capacity and suitability; and risk aversion, to measure how aggressive
portfolios should become.
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 CREATING PORTFOLIOS

Two methods exist to create portfolios based on the collected

information. One uses a scoring system that maps scores to an
efficient frontier. The scoring model and mapping scheme have the
biggest effects on the resulting recommendation for asset allocation.

“robo-advisors,
We hoped that
being
However, they are not necessarily designed to produce optimal
advice for customers. Rather, the design of such systems may be
driven more by considerations of insulating the sponsoring advisor
automated and from liability. For example, if the advisor’s legal department expects
seemingly objective, courts to rule that investors with no investment experience should
would make up for it by hold a low-risk portfolio, then the system’s algorithms could ensure
that this is done.
asking better questions
to find out more about The second method is based on theoretical models about portfolio
the client.
”
—Michael Faloon
choice. This method estimates a customer’s estimated lifetime
earnings and savings, in addition to considering his or her current
household balance sheet. However, this method still makes
simplifying assumptions. It implicitly assumes that each customer is
average in in every aspect of their economic lives apart from age, net
income, and current investments. Thus, the systems may overlook
differences among investors in their ability to take risk, despite
having the same or similar age, net income, and current investments.
Moreover, the systems may produce recommendations that fall
short of meeting economic suitability requirements and being in a
customer’s best interest. The exception is tax optimization. “That’s
something that robo-advisors do really well,” says Faloon.

THE BUSINESS MODEL

“ Cheap access to
diversified beta through The very business model of a robo-advisor can create inherent
conflicts of interest. Lower interest rates make it difficult to justify
ETFs may be part of a high fees, and the main value proposition of current robo-advisors
philosophy, but it also is to provide cheap access to diversified beta in the form of passive
helps to keep head ETFs. “Cheap access to diversified beta through ETFs may be part
of a philosophy, but it also helps to keep head count down,” says
count down.
—Bernd Scherer
” Scherer. For example, analysts are not required to screen actively
managed funds or provide forecasts of long-term investment
opportunities. Whether this view is truly fiduciary or merely driven
by profit motives is difficult to assess, but the breadth and number
of ETFs that robo-advisors typically recommend for a given client
portfolio is often larger than a traditional financial advisor would
suggest. Although the marginal costs of adding ETFs is low for

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 the robo-advisor, a large number of ETFs increases the complexity
costs and effort of replicating robo-advice free of fees. “It’s difficult
to make money in this market,” says Scherer. The fixed costs per
account are relatively high, so if fees are based on percentage of
assets, the average accounts needs to be relatively large to make any
money.

Robo-advisors might consider engineering a solution that starts

Consider evolving with the household balance sheet and incorporates behavioral and
investor categories— empirical elements. “For example, there’s talk of HENRY—‘high
HENRYs, for example: earners, not rich yet’—” says Scherer. From a financial economics
perspective, the present value of a HENRY’s future earnings make
High Earners, Not Rich Yet him or her quite rich already. One can capitalize a HENRY’s balance
sheet and, because the future wealth is not liquid, a different discount
factor can be used. Using actuarial tables (which are different for
men, women, and those in varying circumstances) could affect a
balance sheet as well. “The strength of this approach is that you can
make the balance sheet very explicit,” he says. “The way forward
is to bring in such ideas from portfolio theory and financial wealth
planning.”

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 Michael Faloon Bernd Scherer
faloon@ourkatahdin.com drberndscherer@gmx.net

Michael is the chief strategy Bernd is head of portfolio

officer at Neighborly, which he management at a private German
joined from Standish Mellon bank, overseeing more than $5
Asset Management, where he billion in assets for private wealth
served as COO of the $150 billion clients. He was previously the
investment firm. Michael has 18 chief investment architect at
years of experience in various Deutsche Asset Management
roles at Standish, including head and led efforts to build its
of risk management, municipal robo-advisor. He was also a
bond portfolio manager, and professor of finance at EDHEC
municipal credit analyst. He was and managing director and head
also responsible for implementing of quantitative GTAA at Morgan
Standish’s sustainable fixed- Stanley Investment Management,
income philosophy and process. among other senior positions in
Frankfurt, London, and New York.
A board member of Our
Katahdin, a community-based
crowdsourcing platform, Michael
also served as a member of
the executive committee of
the Green Bond Principles.
He is a member of the Global
Association of Risk Professionals
and holds a Financial Risk
Manager certification. He has a
master’s in financial engineering
from the Stevens Institute of
Technology, a master’s in finance
from Northeastern University,
and a BS from the University of
Maine. He also holds the CFA
designation.

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