What is robo advisor? Here is everything you need to know before investing

What is Smartly? Can I make money when I invest with Smartly? How much can I make? If you are new to robo advisors or you have just started using robo advisors, these are some of the questions which you might probably have.

While there are plenty of articles which aims to demystify how robo advisors work, there are few that shares the inner workings of a robo advisor.

This is part one of the series which aims to explain everything about Smartly. We hope that by the end of the series, you can have a better understanding of how things work.

What are Robo Advisors?

Simply put, Robo Advisors are our digital financial planners which help you manage and invest your savings. Instead of going through the hassle of meeting with a financial advisor, you can find the most suitable investment options by filling up a risk questionnaire. By assessing your risk appetite and investment goals, your risk score will be calculated. Our algorithm will then put together an investment portfolio which consists of various Exchange-traded funds (ETFs) ranging from bonds, equities to commodities.

Having a Robo Advisor is great especially if you’re someone who does not want to pay additional fees to hire a financial advisor and have low investing capital. It is also ideal if you are seeking for a fuss-free solution to diversify, manage and rebalance your investments.

What are ETFs?

ETFs stands for Exchange-traded Fund. It’s a marketable security that tracks different types of index, commodity, bonds or multiple assets like an index fund. Basically, an ETF is a type of fund that has ownership of assets (bonds, gold bars, shares of stock, etc.) which are then divided into shares.

It’s hard to explain what ETFs are without real-life examples so let’s take the Vanguard Total Stock Market ETF (VTI) to illustrate.

The Vanguard Total Stock Market ETF (VTI) tracks the performance of the United States (US) Total Market Index – in other words, it tracks how the US market is doing. This includes tracking the performance of Multinational Corporation (MNCs) such as Apple, Microsoft and Amazon.

As VTI owns the stock shares of these companies, it divides the ownership of these assets into ETF-shares. What this means is that if you invested in VTI, you could get a more diversified portfolio and own shares of these companies. (E.g. For every $100 invested in VTI, you’ll own about $2.91 worth of Apple stocks.)

One common misconception you might be wondering is that by investing in US ETFs, the investments made are only limited to the companies based there. Let’s debunk that misconception with two different scenarios, which show that the ETFs invested are more diversified than what some may think.

  • Many MNCs have offices, employees and products distributed globally. For example, Apple products such as iPhone and MacBook are sold worldwide. This means that their revenue comes from multiple countries rather than the United States only
  • Another ETF which we invest in is the Vanguard FTSE Emerging Markets ETF (VWO). While we purchase this ETF from New York Stock Exchange (NYSE), the VWO invests in stocks of companies located in emerging markets around the world, such as China, Brazil, Taiwan and South Africa

To simplify what we have mentioned above, here is an infographic which shows what happens when you invest with Smartly.

etf_infographic-e1535947438134.pngHow do we select ETFs?

There are over 1,800 ETFs available in the US ETF market, and selecting a pool of ETFs most suitable for you is essential to us. To identify which ETF is the best for you, we use various quantitative and qualitative criteria.

  1. The cost of ownership

    Owning ETFs comes at a cost, and this cost is known as the expense ratio. Deducted on a daily basis, the annual fee of owning ETFs includes management, administrative, operational and all other asset-based costs incurred by the ETF provider.

    To pick the best ETFs for you, we often look for ETFs which have the lowest cost of ownership yet it has the same value or potential since various ETFs track almost the same index.

  2. High liquidity

    What does liquidity mean? Liquidity refers to the degree which an asset or security can be quickly transacted in the market without affecting the price.

    In selecting the most suitable ETF-s, we only select those which have high liquidity for you. High trading volumes allow us to optimise costs and this gives you the flexibility to invest and withdraw at any time.

  3. Physical, not synthetic

    All ETFs we use hold the underlying assets physically. This means there are no derivatives involved, which have resulted in extremely destructive results during global market downturns.

    What is a derivative? A derivative is a financial security with a value that is dependent or derived from an underlying assets or group of assets.

How we construct investment portfolios?

Now that we have carefully selected a vast universe of more than 20 different ETFs, how do we allocate the ETFs to the various portfolios?

The Black-Litterman model is used to allocate ETF-s to different portfolios. It helps us know how much we should allocate to a particular ETF, or to a specific asset class or region. Additionally, we can also create a stable, mean-variance-efficient portfolio of ETFs that maximise expected returns based on your level of risk.

The Black-Litterman model is an asset allocation model (mathematical framework) developed by Fischer Black and Robert Litterman of Goldman Sachs. It is essentially a combination of two main theories of Modern Portfolio Theory (MPT) – The capital asset pricing model (CAPM) and Harry Markowitz’s mean-variance optimisation theory, introduced by Harry Markowitz in 1952.

If you are interested, you can find out more over here. It provides a step-by-step guide on how you can implement it for your portfolio.

Backtesting the various portfolios

Before we implement an investment strategy, we have to use historical data to stimulate performances and business cycles. This process is called backtesting. It’s an important process because we want to make sure that the investment strategy is fundamentally sound and would likely yield profits for you.

For instance, we can take data from 10 years ago and assess how your portfolio would have profited based on those circumstances. We can also understand the underlying correlation between assets and whether they have changed.

Although using past results to represent future performance can be difficult, backtesting allows us to analyse the risk and profitability before risking any actual capital. The last thing we would want is for you to lose your investments.

With all these algorithms and back-testing in-place, we have constructed ten different portfolios that could meet your investment needs and risk appetite. One of the portfolios will be recommended to you based on the answers you provide in the questionnaire when you sign up with us.

Click here to find out what type of investment portfolio is most suitable for you. And if you have any questions, feel free to check out our FAQ or contact us directly. We are always more than happy to help.🙂

We know this is a lot to take in at the moment, so we will leave you with this for now. We hope you have a better understanding of how your portfolio was built. In the next part, we will share with you the investment process — “What happens when you transfer the money to us?”

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