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Automated investment services, known as robo-advisors, are designed to give ordinary investors sophisticated portfolio management at a low cost.
What these investors might not know is how much control robo-advisors can have over their portfolios, especially when markets are volatile.
The robo-advisor Betterment illustrates the point.
After results of the Brexit referendum showed that the U.K. had voted to leave the European Union, the investment tool halted trading on June 24 from the opening bell of the U.S. stock market until about noon Eastern time. (The S&P 500 fell 3.2 percent that day.) Betterment, which manages $5.1 billion, did not inform its retail clients until after the halt had ended. And it didn't have to either.
Robo-advisor accounts are discretionary. That means they have the ability to invest client assets however they see fit. The same goes for human financial advisors. However, clients can call their human advisors and override their decision if they want.
Betterment argues that trading halts are a feature, not a bug of its service.
"We are not a platform for day traders seeking immediate execution," said Arielle Sobel, a Betterment spokeswoman. "Our client agreement outlines our trading policy as a discretionary advisor. We also consistently educate existing and potential customers that our platform is built for long-term focused investors, not day traders." In fact, Betterment experienced an increase in new customers after the Brexit trading halt, Sobel said.
More than day traders take advantage of market volatility to enhance their returns. For example, a long-term investor might want to buy when the market dips, said Ken Schapiro, founder and president of Condor Capital, a financial advisory firm in Martinsville, New Jersey, which manages $900 million.
"People are really buying a black box when they go with a robo-advisor," said Schapiro, who has been tracking the portfolio performance of 13 large robo-advisor services for the past three quarters. "There's no track records on their websites, so you can't compare and contrast."
Betterment outlined its trade-execution strategy during Brexit in a blog post. It typically doesn't trade in the first half hour of trading or on days when the Federal Reserve makes announcements about interest rate policy. It also monitors market depth, bid-ask spreads and volatility when it determines whether to halt trading.
The last time Betterment delayed trading similar to what it did after Brexit was Aug. 24, 2015, when fears of a China slowdown lead to wild market swings as many exchanged-traded funds briefly traded below the value of their underlying investments and the S&P 500 plunged 3.7 percent.
Betterment is reviewing its policy for alerting customers when trading halts, Sobel said.
Other robo-advisors take a variety of approaches when it comes to trade execution:
Vanguard Personal Advisor Services, which has $41 billion in assets under management, uses mutual funds that trade only once per day, after the markets close at 4 p.m. ET, so it doesn't restrict trading. Many robo-advisors, including Betterment, use exchange-traded funds in their portfolios, which can be traded throughout the day.
Schwab Intelligent Portfolios, which has $8.2 billion in assets under management, does not trade in the first or last half hour of the trading day and simply rebalances its portfolios once a day.
Wealthfront, which has $3.5 billion in assets under management, has never halted trading due to market volatility. "The Friday after the Brexit news was no different. Given that the market trading was orderly that Friday, we saw no reason to suspend trading," said Kate Wauck, a Wealthfront spokeswoman.
Personal Capital, which has $2.8 billion in assets under management, generally avoids trades near the market open and close. However, if a client mandates a trade, Personal Capital will honor the request, a spokeswoman said.
Robo-advisors aim to prevent clients from over-reacting to market swings, said Scott Smith, a director at Cerulli Associates, a financial services research firm.
Cerulli has predicted assets managed by robo-advisors will rise 2,500 percent by 2020 to $489 billion.
"Unless clients are bluffing on risk tolerance questionnaires, robo-advisors are doing what they are supposed to do," Smith said.
Last year, the Securities and Exchange Commission and the Financial Industry Regulatory Authority put out an investor alert about automated investing tools, which by their definition includes robo-advisors. The federal regulators advised investors to be aware of the terms and conditions of such services and consider their limitations.
Neither the SEC, which oversees registered investment advisors, nor FINRA, which oversees the trading by advisors and brokers, have filed any enforcement actions against robos.
"Providing financial advisory services electronically is different than the traditional adviser model, but in many respects our assessment of robo-advisors is no different than for a human-based investment advisor, " SEC Chairwoman Mary Jo White said in March 31 address at Stanford's Rock Center for Corporate Governance.
Yet at least one state securities regulator believes robo-advisors need more oversight.
In April, the Massachusetts Securities Division said robo advisors that want to register in the state would be evaluated on a "case-by-case basis." Then, on July 14, the regulator issued guidelines for state-registered advisors who use robo-advisor services.
Massachusetts Commonwealth Secretary William Galvin, who runs the securities regulator, said he is not against technology. He wants to prevent state-registered advisors from charging excessive fees when they direct clients to robo-advisors.
"Robo-advisors can't substitute for a human being," Galvin said.