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Robo Advisor Performance: Beware Hypothetical Returns

Robo advisors have been getting a great deal of press and the rate at which they are attracting new clients and growing assets under management is impressive.  One topic that I have seen nothing written about is how these firms show the historical performance of their strategies to potential investors.

When you look at a chart of a mutual fund’s or ETF’s historical performance, you are seeing actual realized performance: how real money performed when invested in the fund.   The robo advisors provide charts that are labeled as historical performance but these charts may, in fact, be showing what they think their strategy might have done in the past.  Because it is quite simple to construct models that would have done well in past market conditions, this type of backward-looking analysis should not be mistaken for actual historical performance. 

Examples of Robo Advisor Performance Charts

Wealthfront

Source: Wealthfront.com

 

Wealthfront is the one of the largest robo advisors, with more than $2 Billion dollars under management.  The chart above shows something labeled as Historical Performance of a portfolio that is being suggested for a potential client.  The fine print below the chart explains that this is not historical performance as a mutual fund or ETF reports but is, instead, ‘hypothetical…one possible approximation of how Wealthfront’s recommendation might have performed in the past.’  In industry parlance, this chart is what is referred to as a backtest.

Betterment

Source: Betterment.com

 

Betterment, another well-known, robo advisor allows users to ‘see performance data’ for its strategies (see chart above) over various periods, but this performance data is also entirely hypothetical (e.g. backtests).  If you click in a link titled ‘additional data, options, and disclosures’ you can read that ‘historical performance numbers are based on a backtest.’

How Funds Show Historical Performance

By contrast, when a fund company shows a chart labeled as the performance of a strategy, they are showing realized performance.  This is to say that the fund had to be in operation at the time for which the performance is shown and that money invested in the fund for the period shown would actually have provided the returns shown on the chart.

Vanguard

Source: Vanguard.com

The chart above shows historical performance for a Vanguard mutual fund.  The chart, obtained from Vanguard’s website, is labeled as Performance and shows how the value of $10,000 invested in the fund would actually have grown over the period.

iShares shows similar charts labeled as Performance for its ETFs (see below).

iShares

Source: iShares.com

Conclusions

When robo advisors provide charts showing returns from their strategies and labeled as ‘performance,’ the actual data provided may show only that the firms have been able to construct a strategy, with the benefit of perfect hindsight, that would have performed as shown.  When a fund shows true historical performance, the data provided has to be what an investor could actually have achieved if they had invested money in the fund at the start date shown.  These are very different types of information.  The robo advisors explain what they are showing and doing in the fine print or by following additional links.  Potential investors looking at performance charts provided by robo advisors need to be very cautious as to any conclusions that they draw, on the basis of the specifics of how these firms choose to create the data that goes into a ‘performance’ chart.

Folio Investing has concluded that the best way to provide meaningful historical performance charts is to show only real returns.  Folio Investing developed and tracks more than 160 model portfolio strategies, called Ready-to-Go folios.  Starting more than five years ago, the firm put money into each model to ensure that potential investors would be able to see the most meaningful representation of past performance.  The performance data shown on the website for at least the past five years is the actual returns of these accounts.  Prior to funding these models, the model performance was tracked on paper using closing prices each day.  At no time has Folio Investing ever shown backtests and labeled them as historical performance.

Without some consistent and reasonable standards for reporting performance, potential investors cannot meaningfully compare alternatives.  The fund industry has a set of common standards.  It is not unreasonable for robo advisors and other firms that purport to show performance of model portfolios to do the same.

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