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M ichael Faloon utomated asset management (a l locat ion cond it iona l on va r y ing
is chief operating officer advisory firms, often called robo- investment opportunity set), and finally, per-
at Standish Mellon Asset
advisors, assign risky portfolios sonalize (model household balance sheets and
Management in Boston,
MA. to individual investors based on individual preferences). Following Sharpe’s
mfaloon@standish.com investment algorithms. These algorithms taxonomy, the main unifying value proposi-
use investor characteristics such as age, net tion of current robo-advisors is to provide
Bernd Scherer income, and assessments of individual risk cheap access to diversified beta. This is not
is chief investment aversion to recommend suitable asset allo- surprising, given that most robo-advisors are
architect at Deutsche Asset
Management in Frankfurt,
cations. Client interaction and delivery of deeply convinced of the advantages of passive
Germany, and a research portfolio advice are web-based and without investing. A focus on diversified exchange-
officer at EDHEC Risk human interaction. Robo-advice disinter- traded fund (ETF) portfolios reduces client
in Nice, France. mediates the classical distribution model, costs and has strong empirical and theoretical
drberndscherer@gmx.net which is now widely recognized as expen- backing. It also keeps headcounts down on
sive, difficult to scale, and unacceptably het- the robo-advisor side: No analysts are needed
erogeneous (i.e., highly dependent on the to screen actively managed funds or provide
individual advisor’s skill level). Two catalysts forecasts of time-varying investment oppor-
are at work. First, lower interest rates make it tunity sets. Whether this view is truly fidu-
increasingly difficult to justify high fee levels. ciary or just driven by business economics is
Second, we see a shift from defined-benefit difficult to assess. The careful observer will
to defined-contribution plans around the note, however, there is a prevalence of passive
world (a result of poor risk sharing between investing among virtually all robo-advisors.
corporates and pension fund beneficiaries). The breadth of ETFs in terms of spanning
Individual investors need to take responsi- available risk premiums differs among robo-
bility for their own investments, and those advisors, and the number of ETFs that enter
with lower levels of wealth that do not meet a given client portfolio is, on average, larger
minimum account limits are left stranded than what two-fund separation would suggest.
with little access to financial planning advice. Although the marginal costs of adding ETFs
This is where the robo-advisor comes in. is low for the robo-advisor, a large number of
Sharpe [2008] outlined four guiding ETFs increases the complexity costs and effort
principles for investment advice: diver- of replicating robo-advice. This stops clients
sify (investments in a broad universe of robo-advisors from replicating portfolio
of assets spanning all available sources of advice on a fraction of personal wealth shown
excess returns), economize (awareness of to the robo-advisor, while replicating advice
transaction costs and fee layers), contextualize on the bulk of wealth free of percentage fees.
Exhibit 2
Four-Fund Separation
Note: Speculative demand, diversification demand, and hedging demand for investors with balance sheets according to Exhibit 1.