I Robo: The Rise of the Robo Advisor

Think Ahead About Your Role in a Robo Advisory World

Financial innovation is here and it is here to stay.  Financial advisors, broker/dealers, hybrids, and even financial planners should be thinking about how to adapt to inevitable changes launched by disruptive investing technologies.

Robo Design — Chip designers have been using it for decades

I have an unique perspective on technological disruption.  For over ten years, my job was to develop software to make microchip designers more productive. Another way of describing my work was to replace microchip design tasks done by humans with software. In essence, my job was to put some chip designers out of work. My role was called (digital circuit) design automation, or DA.

In reality my work and the work of software design automation engineers like myself resulted in making designers faster and more productive — able to develop larger chips with roughly the same number of design engineers.

Robo Advisors: Infancy now, but growing very fast!

“The robos are coming, the robos are coming!” It’s true. Data though the end of 2014 shows that robo advisors managed $19 billion in assets with a 65% growth rate in just eight short months. This is essentially triple-digit growth, annual doubling.  $19 billion (likely $30 billion now), is just a drop in the bucket now… but with firms like Vanguard and Schwab already developing and rolling out robo advising option of their own these crazy growth rates are sustainable for a while.

With total US assets under management (AUM) exceeding $34 trillion, an estimated $30 billion for robo advisors represents less than 0.1% of managed assets.  If, however, robo advisors grow double their managed assets annually for the next five years that amounts to about 3% of total AUM management by robo advisors. If in the second five years the robo advisory annual grow rate slows to 50% that still mean that robo advisors will control in the neighborhood of 20% of managed assets by 2025.

“Robo-Shields” and Robo Friends

Deborah Fox was clever enough to coin and trademark the term “robo-shield.” The basic idea is for traditional (human) investment advisors to protect their business by offering robo-like services ranging from client access to their online data to tax harvesting. I call this the half-robo defense

Another route to explore is the “robo friends”, or “full robo-hybrid” approach. This is partnering with an internal or external robo advisor.  As an investment advisor, the robo advisor is subservient to you, and provides portfolio allocation and tax-loss harvesting, while you focus on the client relationship.  I believe that the “robo friends” model will win over the pure robo advising model — most people prefer to have someone to call when they have investment questions or concerns, and they like to have relationships with their human advisors. We shall see.

What matters most is staying abreast of the robo advisor revolution and having a plan for finding a place in the brave new world of robo advising.

 

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Dividends and Tax-Optimal Investing

The previous post showed after-tax results of a hypothetical 8% return portfolio. The primary weakness in this analysis was a missing bifurcation of return: dividends versus capital gains.

The analysis in this post adds the missing bifurcation. It is instructive to compare the two results. This new analysis accounts for the qualified dividends and assumes that these dividends are reinvested. It is an easy mistake to assume that since the qualified dividend rate is identical to the capital gains rate, that dividends are equivalent to capital gains on a post-tax basis. This assumption is demonstrably false.

Tax Efficiency with dividends.

Though both scenarios model a net 8% annual pre-tax return, the “6+2” model (6% capital appreciation, 2% dividend) shows a lower 6.98% after-tax return for the most tax-efficient scenario versus a 7.20% after-tax return for the capital-appreciation-only model. (The “6+2” model assumes that all dividends are re-invested post-tax.)

This insight suggests an interesting strategy to potentially boost total after-tax returns. We can assume that our “6+2” model represents the expected 30-year average returns for a total US stock market index ETF like VTI, We can deconstruct VTI into a value half and a growth half. We then put the higher-dividend value half in a tax-sheltered account such as an IRA, while we leave the lower-dividend growth half in a taxable account.

This value/growth split only produces about 3% more return over 30 years, an additional future value of $2422 per $10,000 invested in this way.

While this value/growth split works, I suspect most investors would not find it to be worth the extra effort. The analysis above assumes that the growth half is “7+1” model.  In reality the split costs about 4 extra basis points of expense ratio — VTI has a 5 bps expense ratio, while the growth and value ETFs all have 9 bps expense ratios. This cuts the 10 bps per year after-tax boost to only 6 bps. Definitely not worth the hassle.

Now, consider the ETF Global X SuperDividend ETF (SDIV) which has a dividend yield of about 5.93%. Even if all of the dividends from this ETF receive qualified-dividend tax treatment, it is probably better to hold this ETF in a tax-sheltered account. All things equal it is better to hold higher yielding assets in a tax-sheltered account when possible.

Perhaps more important is to hold assets that you are likely to trade more frequently in a tax-sheltered account and assets that you are less likely to trade in a taxable account. The trick then is to be highly disciplined to not trade taxable assets that have appreciated (it is okay to sell taxable assets that have declined in value — tax loss harvesting).

The graph shows the benefits of long-term discipline on after-tax return, and the potential costs of a lack of trading discipline. Of course this whole analysis changes if capital gains tax rates are increased in the future — one hopes one will have sufficient advanced notice to take “evasive” action.  It is also possible that one could be blindsided by tax raising surprises that give no advanced notice or are even retroactive! Unfortunately there are many forms of tax risk including the very real possibility of future tax increases.

Managing Portfolio Taxes and Tax Risk

Portfolio Tax-Management is Key to Attracting and Keeping High-Net-Worth Investors

With the right tools, the most reliable way to generate portfolio alpha is via tax alpha. One way to look at traditional alpha is as a zero-sum game (after subtracting risk-adjusted market returns). Very smart people with substantial financial backing are searching for tradition alpha every day. The competition for alpha is intense, and tautologically when someone generates positive alpha, elsewhere in the market others are offsetting with negative alpha.

Producing tax alpha, however, can be a viewed as win/win cooperative “game” involving the investment advisor representative (IAR) and client. Among the IAR’s many tasks in creating positive tax alpha is asking for regular (quarterly or twice-per-year) updates on the client’s tax situation and expected tax bracket. The client’s responsibility is to monitor and know their tax situation and to provide timely and accurate updates when their expected tax situation has significant changes.

Net-net worth investors tend to be both more tax savvy and tax aware than other investors. Whereas $5M in liquid assets used to be the threshold where investors expect and demand portfolio tax management, investors at the $2M and even $1M level are increasingly demanding portfolio tax management.

Firms that fail to offer effective portfolio tax management services are at risk of losing their most revenue-producing clients. Conversely, firms that offer and effectively communicate quality investment tax-management services stand to win highly sought-after high-net-worth advisory clients.

Developing a Tax-Aware Portfolio Mindset

Effective investment portfolio tax management begins with awareness of the tax implications of investment actions. As a rule of thumb, the two most tax important considerations are:

1. Awareness of whether asset sale will: A) Generate a large capital gain or loss. B) Result in a short-term (ST) or long-term (LT) gain or loss.
2. Awareness of the client’s: A) Tax situation, B) Tax preferences.

After choosing to increase one’s own investment tax proficiency, we advise clients to begin slowly and focus primarily on tax awareness for the first month or two. There are many reasons we favor this approach. First there is a tendency to initially swing to a tax-first mentality. We believe that it is best to maintain an investment-first mentality, with tax-awareness and tax-management playing an important secondary role in most cases. Developing a tax-aware mentality requires much more mental energy, especially in the beginning. Much like an amateur juggler adept at juggling three balls, adding a forth is very difficult at first, and it dropping one (or more) balls is increasingly likely. If overwhelmed it is best to drop the “tax ball” first, and pick it up later when circumstances permit.

Our view is that it takes 2-3 months of effort to reach a point where portfolio tax awareness becomes largely second nature. It is only after tax consciousness becomes second nature that the foundation for investment tax mastery is ready. Up until this point, and advisor can learn and become modestly proficient with a small number of basic tax techniques. The long-term goal of developing portfolio tax mastery is an art that requires attention, knowledge, creativity, and perseverance. The benefits to both the client and the practitioner are well worth the effort.

Portfolio Tax-Management Corporate Training

We at Sigma1 are working diligently to develop a set of portfolio tax-management training modules ranging from basic to advanced. We have begun offering limited free “beta” courses in investment management tax basic and intermediate level techniques to investment professionals in the the Northern Colorado region. All we ask in exchange is for participants to agree to fill out a brief survey on the day of our presentation and a followup survey in 6-8 weeks to see if and how they are using the training in their investment management process. If you or your firm is interested in participating in this free beta training, feel free to contact us.