The markets have been violently erratic during the last few months due to the COVID-19 pandemic. The high volatility and uncertainty have made it difficult for even professionals to protect their wealth, let alone novice investors. With investors losing money left and right, could robo-advisors be the answer?
When the S&P 500 crashed in February 2018, many leading robo-advisors including Betterment and Wealthfront went offline. However, robo-advisors have come a long way since then. We take a look at how Robo-advisors could protect your portfolio during a market crash, and how they performed over the course of the COVID-19 crisis.
The State of The Markets
As the effects of COVID-19 started to become apparent, the vast majority of asset classes took a hit. Not only did the S&P 500 fall all the way from 3387 to the low 2000s (a loss of almost 38%), but bond yields also took a massive hit after the Fed cut rates.
As it became apparent that the pandemic will not end anytime soon, investors lost confidence in the market. The decline in economic activity and demand for goods meant that a lot of companies that made up the S&P 500 simply had no one to sell to. Essential businesses, on the other hand, continued to operate and their prices skyrocketed.
Oil also crashed due to falling demand. Producers failed to cut production, with Saudi Arabia and Russia entering a price war. Later on, the nations of OPEC+ did strike a deal to lower production by 9.7 million BPD (production by OPEC+ countries was over 41 million BPD – Barrels Per Day – in January 2020 and rising). Still, the US failed to cut its production, which led to WTI (West Texas Intermediate) crude being sold at a negative price. The negative price occurred mainly due to companies running out of storage space to take delivery of the contracts.
We saw many alternative investments also fail. Bitcoin, believed to be a hedge against a global economic crisis by its supporters, failed miserably. Bitcoin fell around 52.55% from its highest value on February 14 to its lowest on March 12. While it has recovered recently, this has been in line with other asset classes and does not make crypto a viable hedge. Overall, it seemed very difficult to find something that could actually protect your wealth during these tumultuous times.
How Robo-Advisors Performed During The Pandemic
In order to compare the performance of robo-advisors, we will use the S&P 500 as the benchmark. By the end of March, the S&P 500 had fallen roughly 19.09% from its value at the beginning of 2020. Robo-advisors showed mixed performance depending on their allocation levels. We expect this as each robo-advisor allocates your money in a different manner.
Some robo-advisors performed quite well. A Betterment portfolio with 50% stocks and 50% fixed income distribution returned -13.1%, almost 6% better than the S&P 500. However, private client investors returned -10.6% on average if we look at Betterment’s own calculations. That is to be expected, considering the fact that Betterment is an automated passive investing system whereas private wealth managers can specifically alter their client’s portfolio to their liking.
The good news is that the vast majority of robo-advisors stayed online during the crisis, despite the massive increase in traffic that they experienced. This shows how robo-advisors are constantly undergoing improvement and they get more robust day by day.
Elsewhere, the results were mixed. A Wealthfront portfolio with a risk profile of 5.0 (average risk) out of 10 returned -7.87% for its taxable portfolio and -6.54% for its tax efficient portfolio. S&P 500 had a return of -5.406% during the same period (from March 2019 to March 2020). Again, we used Wealthfront’s calculations. We will cover tax efficient portfolios in a later article where we explore in detail how they work
Based on the aforementioned statistics, it may seem like robo-advisors fare worse than an index fund when the stock market is down. However, this is not expressly the case. Here is why:
Robo-Advisors Are Usually For The Long-Term
One important thing to remember is that a robo-advisor is supposed to do better than other funds (both active and passive) over the long-term. When you look at a short time span such as 3-months or 1-year, that does not paint a fair picture.
Since there is no active management for a robo-advisor portfolio, the portfolio is not designed with the intention to do well in all circumstances. Instead, it is meant to do well over the course of a number of years (we look at some of the reasons later) and numerous bull/bear market cycles.
The COVID-19 pandemic is an unprecedented situation. As such, it is wrong of us to ask that robo-advisors perform better than the S&P 500 or even actively managed funds during this time. However, there are numerous reasons why robo-advisors are theoretically better than wealth managers right now. Let’s explore a few of them.
Why Robo-Advisors During an Economic Crisis?
There are many reasons why robo-advisors should perform better than wealth managers during a crisis. Of course, this does not apply to all managers. There will always be people who profit massively during a crisis. For example, Bill Ackman at Pershing Square made over $2 billion by betting that credit spreads would widen as the pandemic ramps up (in other words, that riskier bonds would fall in price).
While a robo-advisor cannot compete with moves like this, it is still a great choice for the long run. Let’s take a look at 3 reasons why.
Robo-Advisors Rebalance Portfolios Automatically
This is one of the main advantages of using a robo-advisor. If you have a stock-heavy portfolio, you may be at the prime spot to take advantage of this feature.
When you set up your robo-advisor profile, it will ask you for your risk profile. This profile usually determines the balance between stocks and fixed income securities in your portfolio. The higher your risk profile, the more stock-heavy your portfolio.
During a crisis, it is usually the stock market that takes a huge hit. Bond prices go up as yields fall, so the bond part of your portfolio generates a profit. For example, the YTD (Year to Date) return for the Vanguard USD Treasury Bond is 8.92%. This creates an imbalance, and the robo-advisor rebalancing your portfolio could lead to huge long-term gains.
Suppose you have a portfolio with 50% stocks and 50% bonds. When the stock market crashes, your stock portfolio could fall by 20%, making your portfolio bond-heavy. At this time, chances are that bond prices will be quite high due to investors purchasing safer assets. A robo-advisor will rebalance your portfolio by selling some of the bonds at a profit and purchasing stocks instead.
Stocks will be underpriced at this time, and you will be able to actually increase the number of stocks you own while keeping the same allocation. You will be able to acquire stocks at a cheaper price, leading to huge returns when they eventually rebound. Since robo-advisors invest in ETFs, your positions will be appropriately diversified and you will be in a prime position to capture the upside.
Disciplined Investing
Continuing on from the prior point, one of the biggest disadvantages of a wealth manager is that they start to panic during a market crash. Losses are almost guaranteed during such a period. However, the correct strategy is to alter your portfolio in a way that captures the market rebound in the best way possible.
A robo-advisor will simply stick to the allocation that you determined at the beginning. The negative aspect of this is that risky portfolios will fall quite heavily during a crash. However, they will also experience a similar uptrend when the markets start to return to normal.
Recovery during such times is often slow. In 2008, it took 4 months for the markets to react to the government stimulus package. Human investors, including experienced wealth managers, often lack the patience necessary to sit out market downturns and they start to invest on impulse instead.
If your investment goals are the same, then there is no need for you to alter your strategy during a crash. We have discussed previously how fast thinking destroys your returns. This statement is truer than ever during a time like this, making robo-advisors a great choice for market crashes.
Tax-Loss Harvesting
In our last post on robo-advisors, we discussed tax-loss harvesting briefly. A market crash is a perfect time for a robo-advisor to make sure that your tax liability is as low as possible.
Your robo-advisor will automatically sell stocks and rebalance your portfolio with similar assets in order for you to pay as little tax as possible. Often times, markets rebound much faster than people expect them to. For example, as of 28th April 2020, the S&P 500 has risen 16.5% since the beginning of the month.
A robo-advisor will be able to make sure that in the case that you profit during the tax year of the crisis, you are able to claim maximum deductions against your capital gains tax.
Conclusion
Before we end, it is important to remember that with social distancing measures currently in place, you definitely should not be meeting your advisor. Luckily, hybrid robo-advisors are a perfect alternative. They can allow you to safely talk to an advisor online and get help setting up the perfect portfolio as per your investment goals.
Whether or not robo-advisors are a great investment during times of economic crisis, that remains to be seen. Robo-advisors are a new technology that was not really present during the 2008 financial crisis. As such, this is the first time we are really getting to see how they perform in such conditions. The actual results will only be fully apparent in a few years’ time.
Still, based on the factors discussed above, it does seem like robo-advisors are a good idea right now. The COVID-19 pandemic does seem to be subsiding, but it will be at least a few months before normal business activity resumes.
Some economists have gone so far as to suggest that the pandemic could lead to a lasting recession. In conditions like these, robo-advisors definitely seem like a viable investment platform.
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