Robo-advisors: a step forward for portfolio management?

Currently, not a day goes by without a new article on robo-advisors. Beyond the attraction of novelty, one can wonder if these machines constitute a real progress. Answering that question will take us back to the basics of portfolio management: how to grow financial wealth over time? And can robo-advisors help?

After more than a century of financial history, the conclusion is unequivocal: there is no miracle recipe, investing is more an art than a science. Moreover, even in areas like medicine, a doctor can tell you what to avoid if you want to have a chance to live a long life, but he cannot give you the secret to become a centenary (for Jeanne Calment, former dean of humanity, it was sport and, apparently… a daily glass of Port wine!).

There is no perfect methodology or miracle algorithm in portfolio management, there are only rules derived from decades of experience of those who have really practiced this profession.

 D E C I S I O N – M A K I N G   I N   T H E   F A C E    O F   U N C E R T A I N T Y 

Core tenet: investing is first and foremost about dealing with uncertainty.
We must begin by recognizing that we do not know what tomorrow will bring. Economic and financial forecasts abound but they do not help the investor: they are historically unreliable (the Prakash Loungani study at the IMF showed that economists have predicted only 2 of the last 150 recessions); even when they are right we do not know when they will come true; and even when they come true we do not know how the markets will react. The economist John Kenneth Galbraith used to say: “We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know-“. To what investor Howard Marks adds: ” There are two kinds of people who lose money: those who know nothing and those who know everything”.

So in order to be a good portfolio manager, you have to recognize your inability to predict, and to prepare the portfolio for the largest number of possible outcomes. A good skipper is not a skipper who anticipates the weather and the currents of the next three months, but a skipper who has the right equipment, the right crew and the right skills to face the problems that will undoubtedly occur.

B E   P A T I E N T ,   B E   D I F F E R E N T 

In finance, the shorter the time horizon, the more randomness dominates. Conversely, the longer it is, the more fundamentals prevail. To paraphrase Ben Graham, one of the most respected figures in our field, a long-term investor is the only kind of investor there is.
So patience is key. And the more one is patient, the more one benefits from the eighth wonder of the world, name that Albert Einstein allegedly gave to the exponential growth of a capital whose returns are reinvested (for example, 7.5% per year gives a capital multiplied by 9 in 30 years).

But if portfolio management was just about waiting, our profession would be monotonous. Being patient does not mean being passive or falling prey to herd mentality. On the contrary, to succeed in this field, you have to be different. The legendary investors of the last hundred years have all said it in their own way, from the contrarian movement of John Neff to the approach of Seth Klarman, including of course Warren Buffett, with his famous “Be fearful when others are greedy and be greedy when others are fearful “.

C A P I T A L   P R E S E R V A T I O N   A B O V E   A L L

In the world of finance, goalkeepers David de Gea or Thibaut Courtois would be more famous than Lionel Messi or Cristiano Ronaldo.
Indeed, taking advantage of a bull market is something that everyone can easily do. Over the last 5 years, cumulatively, stocks have gained 71%, corporate bonds 21%, and almost all traditional and alternative assets have increased. Any balanced portfolio (half equities half bonds) could have delivered 7.5%+ annually (USD[1]).

What is fundamental, however, is knowing how to navigate a bear market, and more precisely how to protect the portfolio by avoiding the sudden falls that take decades to recover from (as the truism goes, you have to gain + 100% make up for a drop of -50%). Insuring our home seems logical to all of us – it should be the same for our wealth…

Knowing how to manage a bear market also requires independence of mind and total freedom of action. Because this objective requires, in some cases, extreme actions that institutions such as private banks are not able to take. Why is that the case?
Because their remuneration is largely correlated to the composition of their clients’ portfolios. For instance, a portfolio with active equity funds and private equity is much more profitable than a portfolio with cash and government bonds.

R O B O – A D V I S O R S ,   T H E   T I D E S   O F   C H A N G E ?

I like the quote from François-Serge Lhabitant (a professor at EDHEC Business School): “Robo-advisors are to portfolio management what fast-foods are to gastronomy.”
Indeed, robo-advisors make it possible to democratize the access to a good or a service (here, portfolio management), by offering it to a greater number and for a lower cost. And undoubtedly, they are a real opportunity for financial institutions, enabling them to increase both volumes (more customers) and margins (more automation). But are they an opportunity for the customer as well?

Judging by the principles I have just mentioned, it is far from obvious, because the contradictions are numerous.

Portfolio management is not a science, but robo-advisors need formulas. So the “Modern Portfolio Theory” concepts elaborated by Harry Markowitz in 1952 (!) were once again used[2], to create risk / return optimized portfolios (banks use them as well). By the way, most of the underlying assumptions have since been challenged or proven wrong.

It is impossible to predict the future, but the models need inputs (on future returns, risks, correlations…). So robo-advisors are fed with numerous financial forecasts. For the anecdote, I recently attended a seminar in which one of the world’s largest management and IT consulting firms presented their Robo-Advisory services. Speaking of the models used, the speaker reminded the audience that the first risk was “garbage in – garbage out” … in other words, if the figures entered are not reliable, the results obtained will not be either.

As for the capacity to act differently from the crowd, it disappears of course when we apply and diffuse widely the same tools and models.

C O N C L U S I O N

For those who are looking for portfolio management in the rules of art, there’s nothing new under the sun. Which does not mean that there are no innovations in finance. At Perennium, we have been closely following the developments in the field of Artificial Intelligence, and we are beginning to see interesting possibilities. But we believe that using AI requires simplifying the problems (one cannot feed a machine with all the data in the world and hope that it will predict the stock prices – think about the fact that it has taken until March 2016 for a computer to beat a 9-dan professional Go player).

It should also be kept in mind that in order to manage financial wealth, independence is much more important than size or scale. To the contrary, size can be detrimental. This was one of the reasons for the creation of Perennium in 2013: to have autonomy, independence and a complete absence of conflicts of interests, allowing for portfolio management advice solely focused on the interest of the clients. Clients who for us consist of charitable institutions and NGOs, sharing a common goal: contributing to a better world.

Arnaud Apffel


[1] Using indices MSCI AC World TR in USD and Barclays Global Aggregate USD-hedged respectively, 5 years ending 27 Oct 2017.

[2] With a few bells and whistles so that every firm can claim to have its own “proprietary”, “innovative” models.

 

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