Singapore is thinking of making life easy for robot advisers.
It’s a good idea to let low-cost, algorithm-based wealth managers have their shot at upending the marketplace for financial advice. Clients, especially millennials, are reluctant to pay top-drawer fees for unappetizing returns. The robot-wallahs claim to do a more efficient job, more transparently. They deserve a chance to prove it.
Still, there are risks, and not all of them are equally obvious.
In a recently released consultation paper, the Monetary Authority of Singapore proposed freeing digital advisers from the requirement that, in order to manage retail money, they must have a minimum five-year track record and S$1 billion ($723 million) in assets. Instead, they can obtain a license provided they have the technology and management expertise, and only recommend portfolios that are at least 80 percent in exchange-traded funds.
This pragmatic approach deserves a thumbs up. Besides, the MAS has made it clear that it will hold advisers’ boards and senior managers responsible for back-testing algorithms, and making sure they aren’t tilted toward products that fetch advisers higher fees.
The one risk that could still come back to bite is the false sense of calm inbuilt in the very asset class that digital advisers are expected to stick to: exchange-traded funds.
Singapore is right to insist that digital advisers looking to use its proposed licensing framework use traditional ETFs. These plain vanilla products don’t use leverage to amplify gains, and rather than entering into derivative contracts to deliver the performance of an index, hold a basket of securities passively.
This much protection may be enough when the VIX, investors’ preferred fear gauge, is at 10. But with ETFs continuing to wrest market share away from active investors, the next time the volatility index shoots past 30 — like it did on a number of occasions between 1998 and 2002 and again during the 2008 financial crisis — ETF liquidity might prove to be a mirage. That’s when a bunch of angry investors will want to sue their robot advisers.
Problems are most likely to arise when ETFs are liquid but their underlying securities aren’t. Arbitrageurs who deal directly with ETF sponsors, and buy and sell fund units and their underlying securities to take advantage of price mismatches are shy, for instance, to buy illiquid corporate bonds. As a study published in February showed, market volatility can “severely reduce” the efficacy of the arbitrage mechanism just when mispricing is the highest.
Singapore is in luck. From December 2018, open-ended mutual funds in the U.S., including ETFs, won’t be allowed to hold more than 15 percent of their net assets in securities that can’t be sold within seven days. Until a similar norm becomes a globally accepted code, any faith in ETFs’ safety will carry with it the underappreciated risk of an unanticipated liquidity drought.
That shouldn’t stop Singapore from rolling out the red carpet for robot advisers, so long as the regulator has its eyes wide open.