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How do you get downside risk protection with a robo-advisor?
Robo-advisors have reshaped the investing landscape: They are simple, low-cost, and passive investing almost always outperforms active investing in the long run.
For most people, a set-and-forget passive investing model will produce better results than trying to manage their own portfolio or not investing at all. But while robo-advisors can apply rules based on modern portfolio theory well during bull markets, it can be more challenging to identify the algorithm during corrections, bear markets, periods of high inflation, or periods of higher-than-usual volatility.
“Because robo-advisors take a one-size-fits-all approach, downside protection may be limited,” said Mark Struthers, certified financial planner and founder of Sona Financial. “They typically only use underlying bond ETFs as risk diversifiers, which may not be enough given the potential for stock market declines and bond market declines. Few bots use inflation-sensitive or interest rate-hedged assets.”
Here are some strategies for building risk protection inside or outside of a robo-advisor platform.
DIY method
As interest rates rise, investors may want to increase robo-recommended holdings in risk-conscious investments such as fixed-maturity ETFs (exchange-traded funds), individual bonds, individual TIPs (Treasury Inflation-Protected Securities), or TIP-related mutual funds and ETFs Act as a diversifier, Struthers suggests.
“When you talk about risk, it becomes personal, especially as you get older,” Struthers said. He said he often sees bots using instruments such as iShares’ LQD, EMB and AGG (the Corporate Bond ETF, Emerging Markets Bond ETF and Aggregate Bond ETF, respectively). “These are good basic bond funds, but they may not be enough diversifiers.”
He said he likes Dimension Fund Advisors’ approach to holding core bonds because it aims to outperform traditional index funds and avoid stock picking and timing.
“I know if there’s a market disruption, they have the ability to weather it,” Struthers said. “They don’t have to sell because the index tells them to. If you can find a core that’s low cost and has some common sense risk diversification, that’s even better.”
Another option, says Sean Gillespie, is the Swan Defined Risk Fund, an ETF mutual fund designed to help those struggling to hold on amid headwinds and “buy and Hold” plan for investors who want to earn positive returns while minimizing downside risk to the stock market, Registered Investment Advisor and co-founder of Redeploy Wealth Strategies. “You can build in downside protection: always fully invested and always fully hedged.”
Inside a robo-advisor
Some investment advisors say downside risk protection is the opposite of the robot model. “I don’t think robo-advisors are going to give you downside protection,” said Thomas J. Duffy, a certified financial planner at Jersey Shore Financial Advisors. “Robo-advisors are better than what investment managers are offering,” he said. The price provides an investment experience at a deeply discounted price.” So from a risk protection perspective, you basically get what you pay for.
But some companies, like Wealthfront, are offering services within the platform (for an additional fee) to increase risk-adjusted returns in a variety of market environments through an enhanced asset allocation strategy called risk parity.
“We’re always looking for academically proven, rules-based passive investing strategies,” said Andy Rachleff, co-founder and CEO of Wealthfront, a robo-advisor with $11 billion in assets under management.
Risk parity was popularized by hedge fund giant Bridgewater Associates and offered to institutional investors in the 1990s as “All Weather Funds.” It is based on research showing that investments in certain types of low-volatility stocks may outperform investments in high-volatility stocks.
Wealthfront brings this more sophisticated allocation strategy, once reserved only for the wealthiest, to a wider range of investors. Those with $100,000 in taxable assets can take advantage of risk parity investing. Its risk parity mutual funds have an expense ratio of 0.25%, down from the initial cost of 0.50% when they were launched earlier this year.
Of course, when using a robo-advisor, one of the most sound hedges against downside risk is really old-school and low-tech: an emergency fund.
“If anyone is using a robot and is concerned about the risks, I would make sure you have a large emergency fund,” Struthers said. “Then they can hopefully overcome any shortcomings of the robot.”
CNN Business (New York) First published September 20, 2018: 1:26pm ET