Putting a ROBO adviser to the test, Part 2 (b)

…. continued from Tuesday. Click here for Part 2 (a)) …

By Aman Raina, Sage Investors

Special to the Financial Independence Hub

CANADIAN STOCKS (PORTFOLIO WEIGHTING 10%)

ROBO Goal: Ownership share in companies based in Canada. Often over-represented in Canadians’ portfolios, but a major part of long-term returns.

ETF Used: iShares Capped Composite TSX Index (XIC) MER 0.05%

The investment seeks to replicate the performance, net of expenses, of the S&P/TSX Capped Composite Index. The index is comprised of the largest (by market capitalization) and most liquid securities listed on the TSX, selected by S&P using its industrial classifications and guidelines for evaluating issuer capitalization, liquidity and fundamentals.

Another go-to vanilla ETF, XIC,  provides exposure to the S&P/TSX Composite, which skews heavily into Canadian financials and commodity stocks. One bad habit Canadians investors get into succumbing to home country bias —  holding way more Canadian companies than foreign companies. The Canadian stock market represents only 6 per cent of the global market so it is positive to see ROBO allocating a  smaller weighting to Canadian stocks. It’s sad to say that in terms of investing opportunities, there are way way more of them outside Canada.

RISK-MANAGED STOCKS (PORTFOLIO WEIGHTING 10%)

ROBO Goal: Ownership share in US-based companies. Uses a momentum-based strategy designed to protect investors against big market downturns. Performed very well in 2008 market crash.

ETF Used: Purpose Tactical Hedged (PHE.B) MER 0.90%

The fund seeks to provide shareholders with (i) consistent long-term capital appreciation with an attractive risk-adjusted rate of return investing in a portfolio of North American equities; and (ii) provide less volatility and low correlation to North American equity markets by hedging the fund’s exposure to overall market risk.

This is definitely not a passive-oriented ETF. When you’re trying to make investments that allocate funds to smooth out volatility and minimizing correlation, you probably need a few ROBO advisors and you’re going to pay for it as the MER comes in at 0.90%. What’s that about ETFs being cheap? The ETF invests primarily in US stocks but isn’t the VTI Vanguard US ETF that invests in pretty much the whole US stock market supposed to take care of that exposure?

So why add another US oriented ETF (and a costly one at that) that is likely duplicate some of the Vanguard exposure? In terms of trading volume, PHE.B trades about 7,700 shares a day, implying the asset prices are going to be more volatile. According to its mission, the objective is to “provide less volatility and low correlation.”  Seems contradictory.  Adding the Purpose ETF, our portfolio is now 25% exposed to the US stock market (we’re still not done yet), a market that many (including yours truly ) feel is overvalued.

REAL ESTATE (PORTFOLIO WEIGHTING 10%)

ROBO Goal: North American real estate companies. Acts partly like stocks (capital returns) and partly like bonds (generates cash flow) and also protects against inflation.

ETF Used: Purpose Duration Hedged  Real Estate Fund (PHR) MER 0.65%

The investment seeks to (i) provide shareholders with long-term capital appreciation by investing in a portfolio of real estate focused equity securities listed on major North American exchanges and (ii) reduce the risk of rising interest rates associated with real estate equity securities by tactically hedging the duration of the portfolio. The fund will use a multi-factor, fundamental rules-based portfolio selection strategy to select securities from a universe of North American listed equity securities in the real estate sector. The selection strategy will emphasize factors that have shown to be effective at differentiating between strong and weak performing real estate companies including: fundamental change, valuation, growth and quality.

Look at that! Another Purpose ETF. Remember this company has been around for only a couple of years so the performance history is well … it doesn’t have any! These ETFs haven’t been exposed to a full bull/bear market cycle. Yet our ROBO has crunched the numbers and believes this is the optimal solution for my portfolio. Even so, I’ll yield to ROBO’s assessment. It’s what I signed up for.

Underlying Purpose ETFs are not plain-vanilla products

If it isn’t clear by now, it should be. I’ve come to the conclusion that Purpose ETFs are not plan vanilla ETFs. Clearly they are adopting active management strategies. This ETF charges 0.65%, another very high cost to pay compared to other passive REIT ETFs, which I suspect could get you a similar exposure at a lower cost. 51%  of the ETF is invested in US equities with the rest in Canada. Again, it is likely that the Vanguard VTI ETF will own some of these companies in the Purpose ETF. Just doing some number scratching, it looks like my US exposure is now at least over 30%, with my Canadian equity exposure closer to 15%. The ETF trades on average 286 shares/daily. 286 shares daily! That is practically nothing. There is very little liquidity in this ETF,  which is quite concerning.

EMERGING MARKET STOCKS (PORTFOLIO WEIGHTING 10%)

ROBO Goal: Ownership share in companies based in emerging economies like China, Brazil, Russia, and India. Reduces the portfolio’s risk through diversification and adds the possibility of higher returns.

ETF Used: iShares Core MSCI Emerging Markets (IEMG) MER 0.18%

The investment seeks to track the investment results of the MSCI Emerging Markets Investable Market Index. The underlying index is designed to measure large-, mid- and small-cap equity market performance in the global emerging markets. The fund generally invests at least 80% of its assets in securities of the underlying index and in depositary receipts representing securities of the underlying index.

Again, ROBO has chosen to go with a US$, unhedged ETF. It is much more passive compared to the Purpose ETFs. It has a very portfolio friendly MER of 0.18%. It covers a broad cross section of developing economies.

There it is ladies and gentlemen my ROBO portfolio!

Other Activities of Note

• When setting up the portfolio the ROBO initiated a transaction to convert a portion of the portfolio into US$ so it could purchase more efficiently. In my case they converted $1830CDN to 1453 (1US$ = 1.259CDN)
• It’s interesting that they purchased the foreign ETFs in US$, so now my portfolio has currency exposure with no hedging. There are different schools of thought on whether it is worth hedging currency risk. One side says that over the long term, things even out. The question is what is long term and am I willing to wait that long for an adjustment?
• After the initial investments were made, ROBO decided to purchase additional units of PBD and PHR to rebalance the allocation to their allotments levels. So it appears the ROBO doesn’t waste time when it comes to rebalancing activities.

Overall Observations

I think because my risk score was very high, ROBO concluded that I would be comfortable with a more aggressive investment strategy. High risk, however, should not automatically mean investing in complex assets. It can also mean allocating higher weightings to core positions. I would be curious to see what would have happened to my portfolio  if my risk tolerance was lower. Would ROBO still invest in some of these tactical type ETF funds at all or just assign a lower weighting?

In terms of ETFs selected, I get the feeling I just became a customer of Purpose Investments, with half the portfolio invested in its product line.

It ’s interesting that while almost 60% of the portfolio is invested in foreign ETFs, none of it is currency hedged. It appears my ROBO doesn’t believe in hedging. ROBO appears to be dependent on empirical research and there is a fair bit that says currency hedging doesn’t work and that over the long term, currency fluctuations will smooth themselves out. It’s no big deal right now as the US$ has been on a tear over the last year, so I wouldn’t be surprised to see the returns a bit inflated. If the US$ should stabilize or weaken, it will be interesting to see how ROBO reacts.

I think using the Purpose funds seem like overkill as their funds appear to overlap with the iShares and Vanguard vanilla ETFs. I wonder if just going with the four generic ETFs at higher weightings would be simpler, cheaper, and easier to manage?

The total Management Expense Ratio for this portfolio is 0.45%, which is reasonable. However, this represents only the MER for the ETFs themselves. When you add the 0.50% cut that ROBO takes to cover trading costs and their own margin, we’re now looking at an overall cost of the ROBO portfolio of 0.95%. A 1% all-in cost seems somewhat reasonable and is a lot cheaper than what mutual funds charge. Could this be done more cheaply on my own? Probably but I could see how this could appeal to people who just can’t  be bothered to micro-manage their portfolios and would prefer to outsource it. The question is whether there is enough performance behind it to justify the cost.

Again the point of this exercise is that I am not managing this portfolio. I’ve decided to outsource this small portion of my savings. So I need to suck it up, sing that Frozen song my kid keeps singing and watch how this unfolds. I also realize that to judge the effectiveness of this portfolio at the onset is not fair. We have to give it time but as we travel, I hope we get to learn together a lot more about the intricacies of the Robo Advisor investment model.

Aman Raina, MBA is an Investment Coach and founder of Sage Investors, an independent practice specializing in investment coaching and portfolio analysis services.