Why Robo-Advisers Shun Specialty Funds | DIY Investor Resources

Why Robo-Advisers Shun Specialty Funds

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Robo-advisers stick to ETFs that track the major capped indexes, steering well clear of anything that looks like a sector-specific specialty fund

With investment dollars flooding into online platforms such as Wealthsimple, Justwealth and Nest Wealth, the average investor could be forgiven for assuming that these robo-advisers represent a one-stop shop for any sort of customization imaginable.

In this, the average investor would be mistaken.

In particular, connoisseurs of exchange-traded funds, accustomed to all kinds of targeted strategies that take advantage of specialty funds, may be surprised to learn the robo platforms discourage such speculation. Indeed, they refuse to provide specialty fund options at all.

Jonathan Needham, national sales manager at Toronto-based ETF producer Vanguard Investments Canada Inc., said when it comes to portfolio construction, robo-advisers stick to ETFs that track the major capped indexes, steering well clear of anything that looks like a sector-specific specialty fund.

For practical purposes, Needham said, that means passive portfolio managers generally start with a simple 60/40 split between equities and fixed income, with investments equally divided between Canada, the United States and internationally.

From there, the robos configure the weighting to match a client’s risk profiles — say, by boosting equity exposure, or limiting international exposure — but they never, under any circumstances, express opinions about the sectors or regions that may be in favour in the short term.

James Gauthier, chief investment officer at Toronto-based Justwealth Financial Inc., said online platforms are not meant for people who watch the markets on a month-to-month or even a year-to-year basis.

A client’s risk profile may change over time, but Gauthier said these changes are usually precipitated by major life events — divorce, inheritance, illness in the family — and not by any new investment strategy.

Investors who want to pursue a particular play, or a hot sector, are simply out of luck.

“If you were to tell me that you wanted high returns, rather than specifically technology or commodities, we could give you one of our maximum equity growth portfolios,” Gauthier said, “but we would not get as specific as the sectors.”

Aside from an aversion to speculation, Gauthier said specialty funds are avoided for another reason: they’re expensive. After all, the whole point of using a passive investment structure such as Justwealth is to avoid the expense of active management.

“The combination of speculation and higher costs doesn’t fit well with the long-term investment strategy,” he said.

Gauthier’s process for structuring a passive ETF portfolio starts with a “definition” of what the portfolio is supposed to do. He then looks at forecasts across dozens of asset classes and determines the proper allocation in terms of geographical region, proportion of debt versus equity and yield versus capital appreciation.

Once Gauthier has laid out an allocation that matches a particular portfolio’s risk profile, he begins the more mundane exercise of selecting ETFs that best fit his model. Here, the goal is to find ETFs that best track the required indexes, while allowing for maximum liquidity at minimum cost.

Overexposure to a single company is another consideration, said portfolio manager Michael Allen at Toronto-based Wealthsimple Inc.

“You can’t have any more then 10-per-cent exposure to one particular company,” he said. “That’s important because we don’t want a Nortel to happen.”

Allen, of course, is alluding to the disaster that befell markets at the turn of the century when Nortel Inc., which at the time represented more than 30 per cent of the S&P/TSX Composite Index, collapsed and took out the rest of the market with it. An ETF that perfectly tracks an index isn’t much good if the market itself is a time bomb.

Typically, robo-advisers will offer five to 10 basic portfolio options. For example, Justwealth has five basic fund families that can be customized (taxable/non-taxable, domestic/global) to create 65 total portfolios.

Wealthsimple’s strategy begins with offering clients two strategic investment options: broad-based and socially responsible. For each strategy, the robo-adviser determines, through a series of questionnaires, a client’s risk profile, and puts the client within one of 10 portfolios that sit on a spectrum from conservative to aggressive.

“Through conversations or through e-mail, we can determine if the portfolio that was recommended is appropriate for them, and we can customize it a little bit further for them,” Allen said.

A typical Wealthsimple portfolio comprises seven to 10 broad-based ETFs in Canadian, U.S., foreign and emerging equities as well as government and corporate bonds.

Justwealth portfolios comprise four to eight ETFs, but Gauthier said “starter portfolios” with four ETFs are reserved for investors with limited assets. They may offer the potential for greater returns, but they’re also more volatile and have less access to emerging regions.

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