Robo funds, also called robo advisers, are growing in popularity. Few of us haven't come across advertisements for Nutmeg, Scalable Capital, Moneyfarm, Moola and Wealthify. But what is it that these companies offer, and is it possible to recreate that offering at a significantly lower cost? The answer is "Yes"! This course aims to take you through the steps that will let you build your own robo fund.
If you want to discuss anything in this course or would just like some individual investment coaching then you can find more information and how to sign up for it here Power Hour With Ramin
What services does a robo fund offer?
Robo funds usually do the following things:
- Suitability: You fill out a questionnaire on your attitude and experience of investing
- Matching: Use your responses to choose a portfolio with an appropriate level of risk
- Maintenance: They run that portfolio and let you know how much it's worth
This is usually for a fee of around 1%. The reason why people choose a robo adviser is that they feel they don't know enough about investing to do it themselves or because they can't be bothered to do it themselves. However, it is possible to construct a low-maintenance portfolio that is just as easy to maintain as it would be with a robo adviser, but for a much lower fee.
The following four steps will show you how.
Step 1: Assess your risk profile
All robo advisers have a legal obligation to learn enough about you such that any products they recommend are suitable for your situation. This is why they all require the online equivalent of a financial adviser sitting in your living room drinking your tea and eating your biscuits with a clip-board of questions that you must answer. This is called the "fact find" and the end product for a financial planner is a suitability report that explains how their recommended plan meets your financial goals and also the risks of the plan.
The questions below are the kind of questions that robo advisers, or human advisors, will ask. The purpose of the list to to help you learn about your own attitude to risk and return and choose a portfolio for yourself that matches your capacity and appetite for risk.
How long are you investing for?
The longer you invest for the better. That's because long-term investing dramatically tilts the odds of success in your favour. Compounding of returns will help you more the longer you invest. Furthermore, investing in shares over the short-term is much riskier than investing for shares over the long-term. If you invest in the FTSE 100 for one month you may as well flip a coin to see whether you will get a positive return. As you invest for longer the chance of getting a positive return increases.
For periods of a decade or more the proportion of historic periods that generated a positive FTSE 100 return was much higher (89%) and for a horizon of 15 years the proportion of positive periods was 98%. This is based on data from 1984 to 2018. This means that the switch from "short-term" to "long-term" is at about 5 years, or even a decade. If you're investing for a decade you can put more shares into your portfolio and worry less about market volatility and have a higher chance of good returns.
How long could you live on savings if you lost your income?
This is a risk capacity question. Instead of measuring your attitude to risk it measures whether you should be taking risk in the first place. If you have no savings and are living hand-to-mouth then losing your income would mean selling some of your investments and withdrawing and spending the cash. If this shortens your investment horizon markets may be suffering a temporary downturn when you withdraw money, forcing you to sell at a low price and reducing your long-term return.
A simple way to avoid this unpleasant circumstance is to save some of your money in a low-risk investment, either cash or government bonds, and use this as your emergency fund. That way you never have to touch your long-term investments. There should be enough in the emergency fund to cover your expenses until you can find work again.
How much debt do you have?
This is a risk capacity question. If you have a lot of debt then it may make sense to pay some of this off rather than invest. The benefit of paying off debt depends on the interest rate you are paying on that debt and the return you might receive through investment. There are also tax considerations if your investments aren't held in a Stocks and Shares ISA because you may have to pay income and capital gains tax on your investments. By paying off your debt you will effectively increase your net income by reducing your interest payments. However, while interest rates are low many people invest while still having an outstanding mortgage.
Are you willing to risk your capital for the potential of better long-term returns?
There are a few facts about investing which are unavoidable:
- If you take a low risk you will get a low return on investment.
- If you take a higher risk you might get a higher return or you might lose some proportion of your capital.
The question above tries to work out whether you are aware of the trade off between risk and return. If you feel sick at the thought of losing money then you should opt for a safer portfolio, but if you are willing to take a risk then you can dial up the amount of shares in your portfolio.
Another variant of this question might be:
Are you willing to accept the risk of large losses for the potential of large gains?
What one-year loss would worry you?
The size of a "typical" annual loss for the FTSE 100 is -10%. Or to put this another way every one year in seven the FTSE 100 suffers an annual fall of -10% or more (based on data since 1984). The statistic for the S&P 500 (since 1872) is similar, with a fall of -10% or more occurring roughly one year in five. If you are uncomfortable with this then you may not be cut out for investment in shares.
You should draw comfort from the fact that developed market share indices like the FTSE 100 and S&P 500 have always recovered from selloffs eventually. The worst possible thing to do is to sell your shares or funds when they fall in value.
Are you comfortable with uncertainty in the future value of your investments?
If you want less uncertainty in your return then a long investment horizon reduces this uncertainty. However there is never return without some degree of risk and uncertainty.
If your investments lost half their value what would you do?
The worst thing you can do is sell shares or funds if they fall in value. This is because they may rally again and leave you waiting for another fall before you are willing to buy again. In other words you are then forced to try and time the market to find a new entry point, a skill that eludes almost every investor whether professional or amateur.
When you rebalance your portfolio you end up buying more of the assets that have fallen in value and selling the ones that have gained in value. Another way of seeing the reasoning behind this is you are buying assets that are now cheap and selling the ones that are expensive.
Step 2: Find a cheap platform
An investment platform is the place where you buy, sell, hold and track the performance of your investments. All investment platforms are now run using a website or via an app on your phone or tablet.
We have an entire course on finding the best (not necessarily the cheapest) platform which lists the fees for most of the major platforms in the UK.
The UK government tries to encourage saving by offering tax wrappers such as Individual Savings Accounts (ISA) or Self Invested Personal Pension (SIPP). Most investment platforms offer ISA and SIPP accounts and it makes sense to use these tax efficient accounts to hold your investments. This article talks about ISAs in more detail:
A platform will charge you an annual fee in one of two ways: a fixed annual fee or a percentage fee. The cheapest option depends on how much you have to invest. If you have a large amount to invest then the fixed fee will be cheaper and for a small amount to invest the percentage fee will be cheaper.
For example, say you are comparing a fixed fee platform which charges £100 per year for a Stocks and Shares ISA with a percentage fee platform which charges 0.2% per year. The way to calculate the point at which the fixed fee becomes cheaper is to divide the annual fixed fee by the percentage fee. In this case that would be 100 / 0.002 = £50,000. Beyond an investment amount of £50,000 the fixed fee becomes cheaper. Below this amount the percentage amount is cheaper.
The last thing to check when choosing a platform is that it sells the funds you want. For example, Vanguards own platform sells only Vanguard funds so you can't buy Blackrock Consensus funds if you have Vanguard as your platform.
Step 3: Choose an appropriate fund
Robo advisers create a global portfolio of mixed asset types. For example this may contain shares, bonds, commodities (such as precious metals, oil & gas, grains, industrial metals and livestock), and real estate. Almost all the robo advisers use exchange traded funds to buy exposure to these assets and they do all the fund selection and portfolio rebalancing.
Fortunately there are several cheap, off-the-shelf funds that are diversified across asset types and geographically and which are automatically rebalanced. These come in two types: fixed risk funds and target date funds. Both types of fund perform the basic roles of the typical robo adviser:
Fixed Risk Funds
The risk in a portfolio is driven by the proportion of the portfolio that is invested in shares. The bond component of your portfolio usually carries lower risk and generates less long-term return. By adjusting the amount of shares in a portfolio a fund manager can dial risk up and down.
However building risk-graded portfolios is not a one-shot process. The fund manager has to regularly rebalance the portfolio. Say we start with £60 in the FTSE 100 and £40 in government bonds. This is a portfolio that is 60% equity and £40 bonds. Over a year the value of shares increases to £70 and the value of the bonds increases to £41. This is no longer a 60%/40% equity/bond portfolio it is a 63%/37% equity/bond portfolio. The fund manager would sell some shares and buy to bonds to bring the ratio back to 60%/40%. This rebalancing process can be done more cheaply by a fund manager who can trade at very low cost. The fixed risk funds below do all the rebalancing for you to keep the risk at the level you have chosen.
The cheapest and most popular fixed risk portfolios in the UK are offered by Vanguard and Blackrock. The idea behind both offerings is similar: you choose the level of risk that is compatible with your financial goals.
Blackrock Consensus Funds
These are graded according to the proportion of equity in the portfolio and include
- Consensus 35, ongoing charge 0.22%
- Consensus 60, ongoing charge 0.22%
- Consensus 70, ongoing charge 0.22%
- Consensus 85, ongoing charge 0.22%
- Consensus 100, ongoing charge 0.24%
The fund descriptions state that the funds "may invest in equity or fixed income transferable securities, money-market instruments, deposits and cash and near cash" and that they aim to "achieve a total return for investors". They invest primarily in funds split across several asset classes but derivatives and forward transactions may be used "for the purposes of efficient portfolio management".
The number in the fund's name is an upper limit on the amount of equity it can hold. Blackrock says that each fund "will aim to have no more than X% of its investment exposure in equity securities" where X% depends on the fund name (35%, 60%, 70%, 85% or 100%). So the Consensus 35 fund will have no more than 35% equity at any time but could also have less than 35%.
Vanguard LifeStrategy Funds
I've reviewed these funds (article plus YouTube video) if you want more detail:
The five LifeStrategy funds, like the Blackrock Consensus funds, have graded risk and the same management fee as Blackrock (except for the Blackrock Consensus 100 fund which is a shade more expensive at 0.24%). From lowest risk to highest Vanguard's LifeStrategy suite is as follows:
- LifeStrategy 20%, ongoing charge 0.22%
- LifeStrategy 40%, ongoing charge 0.22%
- LifeStrategy 60%, ongoing charge 0.22%
- LifeStrategy 80%, ongoing charge 0.22%
- LifeStrategy 100%, ongoing charge 0.22%
When Vanguard says 20% it means the equity allocation is (almost) exactly 20% at all times rather than an upper limit, as with Blackrock Consensus funds.
One of the cheapest ways to hold Vanguard LifeStrategy funds is directly through Vanguard's own investment platform which charges you a fee of 0.15% per year capped at £375 per year. This cap means that any funds above £250,000 are invested free of any platform charge.
The all-in fee for this strategy is therefore 0.22% (for the fund) + 0.15% (for the platform) a total of 0.37% per year. That is about a half to a third of the fee you will pay for a robo adviser.
If you have a large amount to invest then a fixed fee platform could be cheaper than using Vanguard's platform. For example Alliance Trust's platform charges £120 per year for a Stocks and Shares ISA. That means that if you have more than £80,000 to invest it would be cheaper to hold LifeStrategy funds on Alliance Trust.
Say you had £200,000 then the £120 fee would be just 0.06%. If you have £500,000 the platform fee would be 0.024%... That means that for very large investment amounts the all-in fee approaches the ongoing charge for the fund of 0.22%. For an investment of £1 million the platform fee is just 0.01% so this adds up to just 0.23% per year.
Target Date Funds
Target date funds are even simpler than risk-graded products like LifeStrategy and Consensus funds because you only need to know one thing: when you need to start spending the investment. You don't need to match your risk appetite and risk capacity to a fund with the right equity/bond risk level. Instead the level of risk is determined by your investment horizon.
Target date funds aim to achieve a good return based on the date when you intend to start drawing on your savings. They do this by reducing the risk of the portfolio over time. They start with a large equity allocation that hopefully generates a high return by taking a higher risk, then as the target date approaches they dial down the risk by moving more money into bonds. This "glide path" then locks in any profits you have made by ending up in a low-risk portfolio.
If you want to learn more about target date funds I've done a review with a video:
Vanguard shows their glide path based on your age below. The equity component falls from 80% up to your early forties then gradually falls to 30% at age 75.
This is the same "composition over time" graph from Vanguard but shows a little more detail in terms of the asset classes that make up the fund over time. Initially the fund has about 60% in global shares outside the UK, 20% in UK shares and the remaining 20% in global bonds (about 15%) and UK government bonds (about 5%). Then when we reach about 20 years before the target date the portfolio starts to shift more into bonds ending up with just over 30% in equity and 70% in fixed income.
Vanguard Target Retirement Funds
These funds all carry an ongoing fee of 0.24% per year. Depending on your age Vanguard recommends a fund that has a target date that is close to your retirement age. For example, if you are 40 in 2018 and will retire at 65 you have 25 years to invest which means you will retire around 2043. That would mean the 2045 fund is appropriate.
- Target Retirement 2015, age 73-78
- Target Retirement 2020, age 67-72
- Target Retirement 2025, age 61-66
- Target Retirement 2030, age 55-60
- Target Retirement 2035, age 49-54
- Target Retirement 2040, age 43-48
- Target Retirement 2045, age 37-42
- Target Retirement 2050, age 31-36
- Target Retirement 2055, age 25-30
- Target Retirement 2060, age 20-24
Step 4: Don't Do Anything
We all have a tendency to fiddle. Unfortunately this tendency will most likely lose money if you are an investor. One of the primary benefits of a robo adviser is that it stops you from tinkering with your portfolio. Financial crises are the time when we are most likely to reduce our long-term returns by selling investments because we fear loss. These articles deal with the cognitive biases that make us our own worst enemy with tips on how to avoid these mental pitfalls:
It is important to do as little as possible until you reach your investment horizon other than invest as much as you can afford. For example if you decide that a 60% equity 40% bond portfolio is suitable for you, then keep putting money into a fund with that risk level. If prices fall you will be buying at a cheap price and over the long-term (decades) prices will almost certainly recover. Think of market selloffs as bargain-hunting.
There is an urban myth bandied about that a fund manager found that their inactive clients outperformed their active clients because they didn't fiddle with their investments. The story probably stems from an interview with Barry Ritholtz on Bloomberg where Jim O'Shaughnessy related the following useful anecdote:
O'Shaughnessy: "Fidelity had done a study as to which accounts had done the best at Fidelity. And what they found was..."
Ritholtz: "They were dead."
O'Shaughnessy: "...No, that's close though! They were the accounts of people who forgot they had an account at Fidelity."
The upshot is that you get the best returns if you play dead.