RobotOne of the more interesting trends in contemporary investing is the emergence of “robo-advisors,” so called because they automate the investment process. Since we here at 3 Factor Indexing are not robo-advisors, people assume we don’t like them. In the titanic struggle between humans and robots, we humans need to stick together, right? In fact, it comes as a surprise to many of our friends that we think robo-advisors are doing a great service to the investment community.

Pro: Robo-Advisors are a welcome addition

In our view robo-advisors earn a gold star for introducing sensible, disciplined investing principles to a wider, often younger audience, which typically has smaller portfolios, perhaps $25-$75K. Many people who are new to investing become intoxicated with the idea that the key to success is buying that one stock which is poised to skyrocket, and selling it the moment it reaches its apogee. Indeed, there is no end to the line of advisors that profess a skill in doing this. In the words of Michael Lewis, author of books like The Big Short and Flash Boys, these advisors claim to know the unknowable. Essentially, they are billing themselves as psychics, prone to confuse luck with skill, and no better at investing than they are at reaching Great Aunt Betsy, who sadly left us for the other side last year. You would do better taking your money to Las Vegas, where at least the house take is lower.

A growing body of academics, investment professionals and institutional investors are puncturing this bubble of astrological thinking, and in our view robo-advisors are a welcome addition to the chorus. Investing is not about stock picking or timing the market. It’s about following the principles of modern portfolio theory, keeping your costs low, and setting up a sensible asset allocation aligned to your investment objectives. It is not about watching the ticker on CNBC. If you find investing exciting, you’re doing it wrong. robo-advisors, in our view, help spread sensible investment practices. Yet some of the features that make robo-advisors attractive for smaller portfolios become drawbacks for larger ones. Here are several of them.

Con #1: Forced liquidation of existing positions

Most clients with larger portfolios have legacy assets. Our customized approach carefully weighs selling versus keeping them. We map legacy assets we recommend keeping into the appropriate asset classes, and the 3 Factor Engine adjusts accordingly. With a robo-advisor, there’s one simple answer; sell them all, regardless of the tax consequences. Let’s consider what this would mean for a typical 3 Factor Indexing prospect who started investing in 2000 with $1M ($750K in her taxable account and $250K in her IRA). The taxable account would have grown to $1.35M while the IRA would be worth $515K1. Liquidating the taxable account would result in a $151K capital gains tax payment (assuming CA resident).

Time to lower fees to exceed the liquidation cost: 35.8 years

Obviously paying such a gigantic tax bill would be a hard pill to swallow. But would it be worth it? Assuming the robo-advisor and 3 Factor Indexing would achieve the same performance (even though both firms are strict index managers, the performance should be identical, only differing by the difference in fees. While we believe that 3 Factor Indexing’s clients should experience higher returns from whole portfolio rebalancing and enhanced index funds, we won’t use this in this hypothetical example). So: how long would it take for the investment in the slightly lower cost advisor to pay off? A whopping 35.8 years2. Pretty clearly, robo-advisors are really only suited for folks who are just starting to build their nest egg.

Con #2: No support for multi-account portfolios

Robo-advisors also typically support only one account. Most of our clients have multiple accounts, some taxable, some tax-deferred (e.g. IRAs), and some tax-free (e.g. Roth). By placing tax-efficient asset classes in taxable accounts and tax-inefficient asset classes (e.g. Bonds, REITs, etc.) in tax-advantaged accounts, you can lower taxes (this is technically referred to as ‘optimal asset location’). Our software, the 3 Factor Engine, automatically does this.

Supporting multi-account portfolios also allows the 3 Factor Engine to lower taxes when rebalancing. A properly invested portfolio allocates the funds across multiple asset classes, such as US equities, International developed equities, fixed income securities, etc. If an asset class is enough above its target level such that some of its securities should be sold, the 3 Factor Engine will first look for securities in a taxable account it can sell at a loss. If it can’t find any, it will try to do the sale in a tax deferred account, yielding no tax liability. Only after exhausting those options will the 3 Factor Engine go back to the taxable accounts and search for sales that would produce as little capital gain as possible. This elaborate search pattern is only possible when you support multiple accounts and recognize their different tax characteristics.

Research shows that ‘Optimal asset location’ adds 0.33%/year3. This may not seem like much, but thanks to power of compounding, this becomes significant over the years:

Optimal asset location added performance (relative to mirrored account management)4

Starting portfolio value 10 years 15 years 20 years
$1,000,000 $57,360 $116,978 $212,057
$2,000,000 $114,721 $233,956 $424,113
$5,000,000 $286,802 $584,890 $1,060,284


Con #3: Lacking funds by Dimensional Fund Advisors

Another significant advantage we bring to our clients is the ability to employ “enhanced” index funds, such as those from Dimensional Fund Advisors (DFA). DFA employs “patient trading,” securities lending, and other techniques that improve long term returns and lower costs when compared with standard index funds. For a longer discussion, see DFA Pros and Cons. For technical reasons, these techniques can only be employed in mutual funds, not ETFs. So it’s no surprise DFA doesn’t have any ETFs; since robo-advisors only use ETFs, they don’t allow clients to invest in DFA funds. Although past performance does not predict future performance, and constructing an apples-to-apples comparison isn’t easy, our research suggests DFA can add up to 0.49% on to long term returns, when compared with the identical portfolio implemented with standard index funds5.

Again, what could an additional 0.49% return mean? The following table illustrates this effect:

DFA’s historical over-performance relative to standard index funds5

Starting portfolio value 10 years 15 years 20 years
$1,000,000 $84,600 $171,889 $310,453
$2,000,000 $169,199 $343,778 $620,906
$5,000,000 $422,998 $859,446 $1,552,265


Con #4: ETFs only

To keep trading costs down, robo-advisors use Exchange Traded Funds (ETFs) instead of mutual funds. We think ETFs too have done a great service to the investment community, by driving down expense ratios, highlighting the high taxes generated by some actively managed mutual funds, and putting pressure on transaction fees. While we’ve negotiated lower transaction fees on mutual funds for our clients, transaction fees on ETFs are even lower. The problem with ETFs is the bid-ask spread.; you pay more than the fund’s Net Asset Value (NAV) when you buy, and get less than NAV when you sell. On large ETFs, the difference can be as little as a penny per share. But once a portfolio gets above $100,000, the pennies add up, making ETF trades more costly. By contrast, there is no bid-ask spread on a mutual fund. Every buy and every sell occurs at the fund’s Net Asset Value. There are also some mutual funds we like that have no transaction fees, which we typically use when investing small amounts of cash.

Con #5: One-size-fits all investment objectives

Finally, the questions some robo-advisors ask clients up front strike us as simplistic, and the resulting asset allocations are often not something we would recommend. To give but one example, consider a client, age 62, retired, with a portfolio of $2.2M, composed of a $1.6M taxable account, and two IRAs of $300K each. The taxable account includes $600k in legacy securities with a very low cost basis, making liquidation a very painful proposition. Social security payments amount to $30k per year, and her burn rate is $180k per year. Here are the questions the robo-advisor asked:

(1) What is your age?
(2) What is your annual income?
(3) What is the total value of your portfolio?
(4) When investing, do you care more about maximizing gains or minimizing losses? (We said both.)
(5) If your portfolio lost 10% of its value, what would you do? (We said we wouldn’t do much.)

Here were the allocations they recommended:

Assuming the $2.2M portfolio is in one taxable account:
Equities: 82%
Commodities: 5%
Muni Bonds: 13%

Assuming the $2.2M portfolio is in one tax-deferred account:
Equities: 72%
Real Estate Investment Trusts: 15%
Bonds: 13%

This is problematic on multiple levels. First, the client has multiple accounts, both taxable and tax-advantaged, which neither recommendation addresses. Second, Muni bonds are more attractive for those in the highest marginal tax rates, and it’s not clear they’re a good idea for this client. Third, the client would take a large tax hit when selling the legacy assets. Fourth, the elephant in this particular investment room is the burn rate, which is unusually high, and which the robo-advisor never asked about. Finally, let’s split the difference between the taxable and retirement asset allocations and call it 70% equities. Is that a wise allocation, for a 62-year-old drawing down almost 7% of her assets per year? We don’t think so. She could get worse advice from a high cost advisor who has convinced himself he can pick stocks. But we think the client would be better served by a lower percentage of equities, and some exploration of how to lower her burn rate or perhaps turn a passion into a second career.

In summary, we’re pleased to have a new voice in the chorus about index investing, particularly one focused on smaller portfolios. But we think humans still have a role to play in the investment advisory business, especially for portfolios $100k and up.

Bob Sawyer
March, 2016

Disclosures and footnotes

Past performance is not a predictor of future performance.
3 Factor Indexing LLC has conducted extensive analysis concerning portfolio performance. Please refer to our website at http:3factorindexing.com/important-disclosure/ for details and disclaimers regarding a statements concerning performance, and the various assumptions we have made in our analysis.
The views and information contained within this article are provided for informational purposes only and are not meant as investment advice. They represent the author’s current good-faith views at publication time and are subject to change without notice. As with any strategy, it is important for an investor to fully understand the strategy prior to investing; seeking advice from a professional advisor can be a good place to start.
The information that is provided herein has been compiled to the best of our ability. However, the authors makes no warranty of any kind, expressed or implied, and will not be held responsible, or liable for errors, or omissions resulting in any loss or damage caused or alleged to be caused, directly, or indirectly, by information contained in3 Factor Indexing’s publications.
Links to other web sites are provided as general information sources for the reader. 3 Factor Indexing has not formally evaluated the information provided via these sites and inclusion of these links does not constitute an endorsement of any organization. The links provided are maintained by their respective organizations and they are solely responsible for their content. Trademarks are the property of their respective owners.

1Assume purchase in 2000 with $750,000 in a ‘60/40’ globally diversified portfolio (60% equities, 40% fixed income with a small & value overweight). On 10/2014 the portfolio would have been valued at $1.34M.
2The $1.34M portfolio would have a $151k unrealized capital gain. After liquidating the portfolio (assuming the investor is a CA resident) the adjusted portfolio would be $1.2M. The cross-over point – where the liquidated/reinvested portfolio exceeds the existing (non-liquidated portfolio) – is 35.8 years, assuming an after tax (per-liquidation) annualized return of 6.5%.
3Asset Location: A Generic Framework for Maximizing After-Tax Wealth, FPA Journal 1/2005. Explanatory chart assume a 6.5% annualized return.
4Table illustrates the difference between two portfolio growing at the same rate (we assumed 6.5%, based on long term historical returns). The portfolio implemented without optimal asset is presumed to grow at 0.33% lower rate. Different starting values of $1M, $2M and $5M are shown for illustration.
5‘60/40’ globally diversified portfolio: 60% equities, 40% fixed income with a small & value overweight. Comparison between portfolios implemented with DFA funds versus an identical portfolio implemented with standard research indices. Assuming 1) robo-advisor advisory fee 0.25% with 0.15% ETF fees 2) 3 Factor Indexing 0.50% advisory fee (mutual fund fees expense ratios effect already included). Performance data from 5/1998 – 9/2014 and rebalanced semi-annually. Note that while advisory clients can purchase DFA ‘live’ funds, it is not possible to purchase research indices. We assume that standard index funds (or ETFs) – whose sole objective is to mirror the underlying indices – will, at best, achieve the performance of the indices. The DFA fund implemented portfolio’s annualized return was 7.19% whereas the research indices portfolio was 6.70%. The allocation is as follows:


DFA Fund Research Indices
14.25% DFA US Small Cap Value Portfolio Class I Russell 2000 Value Index
3.80% DFA Emerging Markets Value Portfolio Class I MSCI Emerging Markets Value Index (gross div.)
28.50% DFA US Large Company Portfolio Class I (expired) S&P 500 Index
5.70% DFA Emerging Markets Portfolio Class I MSCI Emerging Markets Index (gross div.)
7.13% DFA International Value Portfolio Class I MSCI EAFE Value Index (gross div.)
5.00% DFA Real Estate Securities Portfolio Class I Dow Jones US Select REIT Index
14.25% DFA Large Cap International Portfolio Class I MSCI EAFE Index (gross div.)
7.13% DFA International Small Cap Value Portfolio Class I MSCI EFE Small Value Index (gross div.)
14.24% DFA US Large Cap Value Portfolio Class I Russell 1000 Value Index


6Table illustrates the difference between two portfolio growing at the same rate (we assumed 6.5%, based on long term historical returns). The portfolio implemented without DFA funds is presumed to grow at 0.49% lower rate. Different starting values of $1M, $2M and $5M are shown for illustration.