Robo-advisers – online investment management firms that use simple algorithms to place investors into suitable portfolios – have grown in popularity, at least in part, because of low-cost index funds. Evidence suggests that low-cost index funds tend to beat most active fund managers, and robo-advisers tend to use them extensively on that basis.
Wealthsimple, one of Canada’s first robo-advisers, used to proudly proclaim on its website that “nobody beats the market. Instead of trying to pick winning stocks, we track the stock market as a whole. […]”
While “tracking the market as a whole” seems simple enough, the actual performance of robo-advisers suggests there is more to the story. As The Globe and Mail reported in November, there is significant dispersion in Canadian robo-adviser returns.
For the five-year period ending September, 2023, the worst-performing “growth” robo-adviser portfolio returned 3.8 per cent annualized while the best one returned 5.98 per cent annualized.
This means that for the “growth” asset allocation profile – a profile indicating medium-high risk – robo-advisers have delivered materially different returns to their customers.
There are two simple explanations for this dispersion: differences in asset allocation and differences in portfolio management approach. This highlights the importance of doing due diligence on the investment process of any adviser, including a robo-adviser.
Asset allocation
One of the most important contributors to the expected outcome of any investment strategy is asset allocation – how it distributes investments across stocks, bonds, cash and real estate investment trusts (REITs).
Index funds can be used to gain broadly diversified exposure to different markets, but you still need to choose which asset classes you want to invest in.
To gain an understanding of the dispersion in robo-adviser returns, I looked at the asset allocation approaches for a handful of Canadian robo-adviser Growth portfolios: CI Direct (Passive), RBC InvestEase, BMO SmartFolio, Modernadviser, QuestWealth and Wealthsimple.
Looking across the sample of “growth” robo-advisers, some robo-advisers allocate nearly 30 per cent to fixed income while others are below 20 per cent.
Another important aspect of asset allocation is how assets are distributed geographically. A reasonable starting point is global market capitalization weights, but there are sensible reasons to deviate from this. For example, a Canadian investor may want to hold Canadian stocks above their market capitalization weight.
Robo-adviser portfolios differ significantly in this dimension, too. All portfolios are overweight Canadian stocks relative to their market capitalization weight (which is around 3 per cent), but the allocations vary widely. Similar observations can be made for other geographic regions.
Passive or active?
Another key consideration is how the portfolio is being implemented. One of the hallmarks of index fund investing is staying disciplined with a consistent asset allocation over time, often referred to as passive investing, but not all robo-advisers are adhering to this discipline.
Notably, Wealthsimple – Canada’s largest robo-adviser – has made multiple material changes to its portfolios over time. In 2019, it added longer-duration government bonds and inflation-linked bonds, and reduced credit risk.
It also added low-volatility stocks and increased their exposure to international developed and emerging markets. In Q3 2020, it removed shorter-term government bonds and replaced them with a mix of credit, longer-term bonds and gold.
Finally, in March, 2022, it switched up the minimum volatility equity ETF for a different ETF that incorporates other factors (such as quality and momentum), changed its fixed income allocations back to what they were prior to the 2020 change, and reduced its exposure to emerging markets.
It has no doubt made these changes with good intentions, but its performance has suffered relative to a simple buy-and-hold indexing approach. The Globe finds that Wealthsimple’s returns are the lowest among Canadian robo-advisers.
Additionally, marketing materials for the Questwealth portfolios are overt about their active management, which is intended to “limit losses” and look for “opportunities to improve your returns.” Claims like these have been made by active managers for decades, but there is limited evidence supporting their ability to deliver on them with any consistency – including the Questwealth portfolios, whose five-year returns have trailed a passive index fund portfolio.
Over all, robo-advisers have been a positive innovation. Compared with self-directed investors, those using robo-advisers tend to have reduced home-country bias, improved diversification, lower fees and higher risk-adjusted returns. But this does not mean that all robo-advisers are created equal.
Consumers need to be aware that robo-adviser portfolios can differ significantly from firm to firm both in their asset allocations and their approaches to portfolio management. This can lead to the potential for meaningful differences in long-term returns.
There is no “right” approach to asset allocation, but investors should choose a robo-adviser with an approach that they understand, and that they will be able to stick with for the long run.
Editor’s note: (July 3, 2024): A previous version of this article imprecisely stated that Questwealth portfolios have trailed a passive index fund portfolio. Its five-year returns have trailed a portfolio of passive index funds. This version has been updated.
Benjamin Felix is a portfolio manager and head of research at PWL Capital. He co-hosts the Rational Reminder podcast and has a YouTube channel. He is a CFP® professional and a CFA® charterholder.