Behind the Curtain: How Robo-Advisors Really Manage Your Money

Automated investment services - more commonly known as robo-advisory accounts - are relatively simple to understand, on the surface at least.

We talked about this last week - robo-advisories were created by millennials in response to the dot-com collapse, the financial crisis, and traditional fee-based advisory services.

But all is not what it seems. And if you dare dig into how they actually work, you'd be surprised by how complex they are.

Today, I want to show you how these services actually automate portfolio selection and perform rebalancing acts, and help you understand some of the complex portfolio management theories providers have to use.

Because what you don't know can really hurt you - and you should know how your money is being managed.

Let me break it down for you...

Two Approaches, One Goal: Diversification

robo-advisorsThere are two general approaches to how automated investing services construct portfolios. Either they're based on a long-term timeline, or they're built on goals-based investing.

For example, two of the most popular robo-advisory service providers, Wealthfront and Betterment, go in different directions. Wealthfront has a long-term timeline investing platform, while Betterment's platform focuses on goals-based investing.

Betterment explains its goals-based investing focus this way:

When you invest with Betterment you'll notice that we don't give you a risk-tolerance questionnaire. Instead, we ask about time as it pertains to your investments: your age in relation to your goal (with retirement, say) or the time horizon to reach your goal (e.g. three years to save up a Safety Net fund). That's because a goal-specific time horizon is an objective measure of the potential range of outcomes which you should be exposed to.

While you can choose a service based on how long you'll be in the market that rebalances your portfolio based on your changing age, like what target-date funds do, all robo-advisors construct diversified portfolios for you.

The common denominator with a diversified portfolio is they theoretically reduce portfolio risk without sacrificing expected returns.

Don't Miss: This is your ticket to bigger and better returns... and it won't cost you a penny. What are you waiting for? Read more... 

Unfortunately, there's a problem with diversification. Providers mostly diversify you based on the same portfolio management theories.

That means that you may not be special just because you're on a long-term investing platform or on a goals-based platform.

Portfolio diversification is generally achieved through mean-variance analysis or optimization.

Mean-variance analysis quantifies risk and expected returns by applying concepts from statistics, where the values of assets (stock prices) are taken to be random variables with various expected values.

Mean-variance optimization was introduced by Nobel laureate Harry Markowitz in his 1952 paper "Portfolio Selection." It was the first mathematical formalization of the idea of diversification of investments. It considers a set of risky assets and calculates portfolios for which the expected return is maximized for a given level of portfolio risk, where the risk is measured as variance.

Mean variance analysis became known as Modern Portfolio Theory (MPT), where optimized portfolios result in the "efficient frontier," a band of portfolios that dominate all other feasible portfolios in terms of their risk-return tradeoff.

Generally, the return on all securities is correlated to the market return through a constant called beta. The market's beta, a measure of how it moves relative to itself, is always 1 (because it is a measure of itself). Variance analysis includes measuring how individual securities and portfolios vary from the market's beta of 1. A portfolio's beta, the weighted average of the betas of the securities in a portfolio, measures the portfolio's correlation to the market.

But each security's return is also subject to an "idiosyncratic" (non-systematic) term that is independent of the market return and the idiosyncratic terms of all other securities. A portfolio's idiosyncratic term is the weighted average of the idiosyncratic terms for each of the securities.

Since the idiosyncratic term of each security is assumed to be independent of all other securities, the variance of the idiosyncratic term of the portfolio is not the weighted sum of the constituent securities' idiosyncratic variances. It is less than the weighted sum, since the idiosyncratic terms tend to diversify - some are positive while others are negative, canceling each other out. With a sufficiently large number of securities, meaning diversification, idiosyncratic risk can be theoretically completely eliminated.

The One Thing They Won't Tell You

[mmpazkzone name="in-story" network="9794" site="307044" id="137008" type="4"]

The elimination of idiosyncratic risk, theoretical as it may be, is precisely why investors have been pushing for diversification for decades.

However, risk from correlation to the market - systematic risk - cannot be diversified away.

And that's the problem the services don't tell you about.

While you think you're diversified and your magic portfolio is constructed using MPT, aspiring along the "efficient frontier" and fortified by beta weightings, you're fooling yourself.

You are still subject to market gyrations, sometimes "correlating" exactly with them - and usually when markets are tanking.

While modern portfolio theory allows you to diversify away unsystematic or idiosyncratic risk, systematic risk, due to beta, does not diversify away.

According to noted economist and portfolio risk measurement and "beta" pioneer William Sharpe, a financial crisis by definition is a period of time during which systematic risk swamps unsystematic risk.

That's my biggest beef with the complicated investment theories and math that robo-advisors inundate you with.

They don't tell you that all their theories can't stop you from getting your head handed to you if - and when - markets crash.

Now that you know your presumably personally constructed, perfect robo-advised portfolio account can be terminated, at any time, I'll tell you what else is a problem and why all those "personally" constructed portfolios aren't so personal - and might actually be creating a negative feedback correlation loop that itself can tank markets.

And if they do, don't expect the robo-advisors to take any responsibility. Because while they're technically Registered Investment Advisors, they really aren't.

I'll tell you more soon, so don't go anywhere.

This Stock Is About to Skyrocket: This tiny $5 company just passed each of the seven benchmarks in this secret stock-picking method. Learn how to get in before its revenue surges an estimated 4,709%. Read more

Follow Money Morning on Facebook and Twitter.

About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

Read full bio