Morningstar Magazine - June/July 2017 - 53

goals and ask users to prioritize them. But even
in the advanced cases, a user's goals are
typically solved in order of priority, one at a time.
In the near future, robo-advisors will optimize
across goals, providing options for the best
way to achieve the best total outcome across the
most goals. This might include showing the
probability of meeting each goal and include
savings and investment advice tailored to each
goal and the portfolios that support them.
Investment Menu

A focus on passive products is misguided,
when the real focus should be on investment
products that achieve the specified goals
for the lowest cost. An expanded menu could
include active and passive, annuities, and more.
Whether human or machine, investment guidance
tends to align toward areas of specialization
or preference. There's the big broker/dealer advisor
who is most comfortable selling loaded openend funds, the wealth manager who uses
alternatives and hedging, the planner who aligns
toward market indexing, and the robo-advisor
that uses exchange-traded funds. It's hard
to perform due diligence on a broad menu of
investment options.
Today's robo-advisors are overly simplistic, with
most relying almost exclusively on low-cost
ETFs. In fact, they've bought in so deep to passive
investing that most of the robos are formed with
heavy sales and marketing staff, but very few
investment professionals. After all, what's so
hard about selecting a few low-cost index trackers
for just a handful of model portfolios, right?
While there is growing support for the movement
to passive products, the focus should be on
fees, not product structure. That is, we shouldn't
be focused on ETFs or passive, but rather the
lowest-cost products to achieve desired outcomes.
Morningstar's Russel Kinnel has written
extensively on the topic. "The expense ratio is the
most proven predictor of future fund returns,"
Kinnel says. "We find that it is a dependable
predictor when we run the data. That's also what
academics, fund companies, and, of course, Jack
Bogle find when they run the data."

Low-cost active funds with great track records and
strong managers should be on an investment
menu. Annuities that provide guaranteed income
for a great price should be on the menu.
In fact, I'm not sure we should limit the type of
product on a menu, but we should definitely limit
the fees we pay for them.

constantly tuned without tax ramifications.
In a taxable account, robos can put new money to
work by deploying new deposits and dividends
toward underweight assets. When selling
overweight assets is required, the robo can identify
the lowest tax impact lots (that don't trigger
short-term gains).

Starting in 2016, some newer robos started to form
model portfolios that blend active and passive
products. But preformed model portfolios are not
the wave of the future. Machines are now
able to create on-demand portfolios for investors,
using optimization techniques guided by the
investment rules of our best money managers. For
example, an optimization technique could be
applied to find the best investments across
ETFs and open-end funds that fit a desired risk
model. The definition of "best" would be defined
programmatically (perhaps high alpha, low
tracking error, low expenses, low price/fair value,
etc.). Robos can get advanced by modeling
annuity products, solving for the appropriate mix
between variable and guaranteed income to meet
goals, and then recommending the suitable
securities and insurance products. One of the most
difficult aspects of evaluating annuities is their
complexity, but a robo can simplify this and
recommend only the ones that are suitable. The
same goes for active fund managers.

The exciting part is when we use robo-advice
across taxable and tax-deferred accounts and all
buy/sell decisions maximize tax efficiency
by determining which accounts and lots would
be the best fits for the transaction. In other
words, it will become more efficient to rebalance
across portfolios at the household level,
and algorithms can simplify this task by putting
the power of institutional rebalancing in the
hands of the average investor.

Rebalancing

Portfolios easily drift off course, but automated
solutions can rebalance tax-efficiently with
appropriate account location in mind.

New Day Coming

Pulling all this together, automated advice
will drastically improve its value proposition over
the coming years. No longer will robo-advice
be relegated to solving only the simplest investing
problems with generic model portfolios, but
instead it will provide highly personalized advice in
a scalable and cost-efficient manner that can
reach an underserved market. In fact, the
technology mentioned in this article is available
today; it just hasn't been stitched together
into a seamless experience yet. That day is coming,
and soon you will look back on personalized
automated advice and say, "I knew it was a good
idea all along!"

Portfolios left untended will migrate into a
risk profile that can look very different from what
an investor has signed up for. For example,
a runup in stocks can shift a 60% equity portfolio
to 80% quickly, dramatically changing the
portfolio's risk. Advisors typically try to meet with
their clients at least annually to review the
portfolio and make necessary adjustments, but this
process is manual and often not an event the
investor looks forward to.

Does this mean that robo-advisors will replace
human advisors? Let me ask it another way. Will
human advisors replace robo-advisors? The
answer to both is the same. As people's financial
lives get more complex, so do their needs.
There will always be opportunity to raise the bar for
what automation can provide, just as there
will always be value in the personal relationships,
guidance, and services only humans can
offer. By embracing the strengths of what
automation can provide, personal advisors will
offer a more compelling continuum. K

Robo-advice offers great advantage when armed
with sophisticated rebalancing tools. A robo
placed within a tax-deferred retirement account
might rebalance often to keep the risk profile

Mike Barad is head of product capabilities
with Morningstar. He was the founding publisher
of Morningstar magazine.

global.morningstar.com/Morningstarmagazine

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