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Robo-Advisors

A robo-advisor is an automated financial planning service that uses machine algorithms and advanced technology to develop and manage an investment portfolio. Because robo-advisors remove the human element from investment management, they are significantly less expensive to use than traditional financial planners, putting professional management services within reach of even small investors.Betterment launched the first robo-advisor service in 2008 at the start of the Great Recession. The market has exploded since then; there are over 200 digital investment platforms available currently, with more in the pipeline. In 2015, roughly $60 billion was under management by robo-advisors. Today, experts project that figure will reach $2 trillion by 2020. According to financial research firm Hearts & Wallets, about half of all investors aged 53 to 64 have assets managed by robo-advisors, as do about a third of all retirees.Although wealth management software is new to consumers, financial advisors have been using portfolio allocation software for almost two decades. There is nothing new about automating many investment decisions. The only “new” thing about robo-advisors is that this technology is now available directly to consumers.Earlier versions of robo-advisor platforms dealt exclusively with taxable accounts and IRAs, but now there are robo-advisors managing more complex investments such as trusts and even 401(k) accounts. Most robo-advisor platforms offer regular portfolio rebalancing, retirement planning, and tax-loss harvesting for taxable accounts. Some offer hybrid services which combine automated investment management with a fixed number of contacts with a human advisor each year.Robo-advisors generally charge between 0.2% and 0.8% to manage a portfolio, compared to an average of 2% for professional wealth managers. On average, you’ll pay about $40 per year for each $10,000 invested with a robo-advisor. The fees are deducted from your account on a monthly or quarterly basis.Account minimums, which are a barrier to entry for many retail investors, are low to nonexistent with robo-advisors. You generally need in the neighborhood of $100,000 in assets for a financial advisor to accept you as a client, but you can open an account with a robo-advisor for $500 or less in most cases, although a few platforms have higher minimums of $5,000 to $10,000.Most robo-advisors offer a fixed number of portfolio options ranging from quite aggressive to more conservative. When you open an account, you’ll answer several online questions, and the platform will recommend a portfolio based on your financial situation and goals.Robo-advisors generally build portfolios around exchange-traded funds, or ETFs. These are low-cost, passively managed funds that track an underlying stock index, such as the S&P 500 or NASDAQ Composite. In a traditional brokerage account, you usually pay commissions on ETF trades, but these are typically waived with robo-advisors. This eliminates the costs associated with regular portfolio rebalancing. It also makes automatic investing and regular share purchases more affordable. Some robo-advisor platforms do allow investors to trade individual securities, although there is often a minimum account balance required for that service.The largest stand-alone robo-advisor, Betterment, has nearly $15 billion in assets under management. Among the legacy financial management firms offering robo-advisor services, Vanguard leads the pack, with over $50 billion in managed assets, although Vanguard’s service is not a true robo-advisor but a hybrid, matching each investor to a human financial planner in addition to automated investment management.Robo-advisors are a good choice for new investors, those with relatively straightforward financial planning needs, and people who prefer a more automatic, hands-off approach to managing their investments. Those with large portfolios, more complex tax situations, or assets such as company stock options, for example, may benefit from a human advisor, or a hybrid approach to financial planning.
Robo-advisors are the “next big thing” in financial planning, and consumers are increasingly choosing automated investment management over human financial advisors, at least for a portion of their investable assets. Current research suggests that robo-advisors will manage 10% of all global assets under management by 2020, or about $8 trillion.There are pros and cons to all financial management services, and robo-advisors are no different. If you are considering automating your investing decisions, these are the advantages and disadvantages you should keep in mind before you make your choice.

Advantages of robo-advisors

Low feesAlthough there are different pricing models for financial advisor services, few can compete with the fees of the cheapest robo-advisors. Human advisors generally charge between 1% and 2% of assets under management for their services, while robo-advisors cost as little as 0.25%. Betterment, the largest and older of the stand-alone robo-advisor platforms, offers one year free before imposing a modest 0.25% management fee, or $25 for each $10,000 invested. They also waive most transaction fees and commissions associated with buying and selling funds.Low to no account minimumsMost financial advisors only work with clients who already have a substantial portfolio, although those working on an hourly fee structure may take smaller investors. Robo-advisors, on the other hand, generally have no account minimums, or minimums of $500 or less. This is especially true of stand-alone platforms such as Betterment and Wise Banyan.Many of the big-name financial management firms such as Fidelity, Vanguard, and Charles Schwab also offer robo-advisor services, usually in combination with more traditional wealth management services. These platforms tend to impose account minimums for access to robo-advisor technology however, typically starting at $10,000.Access to cutting-edge portfolio researchRobo-advisor technology is powered by algorithms designed by Nobel Prize-winning economists such as Robert Shiller and Eugene Fama. The investment theory behind robo-advisor platforms takes the human element out of investing, relying on statistical analysis to create portfolios that minimize risk and maximize returns.Simplicity and availabilityThe average user, with just a few clicks, can open an account and build a portfolio with a robo-advisor in a matter of minutes. A distinct advantage over time-intensive human financial advisor services. There’s also the convenience factor of 24/7 access to your robo-advisor.RebalancingThere’s a body of research showing regularly rebalancing your portfolio to its original asset allocation is key to high performance. Individual investors rarely make the effort to rebalance, and a financial advisor charges a fee for the service. Robo-advisors automate the periodic rebalancing process, usually on a quarterly basis, so that your assets are always invested in line with your preferences and financial goals.Index-matching returnsMost actively managed funds fail to meet their benchmark returns, especially over the medium and long term. Robo-advisors typically invest in ETFs, which are passively managed funds pegged to an underlying index. Generally speaking, ETFs and index funds do a much better job of matching returns. They are also low-cost investments that don’t eat away at your gains with high expense ratios and fees.

Disadvantages of robo-advisors

Limited personalizationMost robo-advisors have a set of portfolios and plug each client into the portfolio that most closely matches his or her investment goals and risk tolerance. They have a limited set of responses to each financial situation, so they may not make sense for people with unusual financial situations outside the “one-size-fits-all” portfolio.No “human touch”It’s hard to overstate the role that emotions play in financial decision making. A declining market or an unexpected personal financial downturn can drive bad investment choices and transactions that are easily executed with a robo-advisor platform. Human advisors, on the other hand, are there to offer perspective and game out different scenarios to help investors avoid rash decision-making regarding their portfolio.Lack of integrationRobo-advisors excel at simple financial planning tasks such as retirement calculators and balanced asset allocation in taxable accounts. Where they fall flat is in integrating all your financial needs, such as tax and estate planning, into one cohesive plan.Less flexibilityRobo-advisors focus almost exclusively on ETFs; few trade individual securities or offer other asset classes to round out your portfolio. In addition, risk management strategies such as options, are beyond the algorithmic capabilities of a robo-advisor.The robo-advisor industry is still in relative infancy, and newer platforms may address some of the limitations that are inherent in the automated investment management model. Ultimately, the decision to use a robo-advisor for some or all of your portfolio depends on your overall investment goals and personal style.
That is a difficult question to answer. The algorithmically driven portfolios robo-advisors create for their clients are all different, containing a different mix of different ETFs, and with different underlying asset allocations, so there’s no real benchmark with which to compare performance across the different platforms.In other words, there isn’t a “standard” portfolio across all robo-advisors you can use to compare. With index funds, for example, you can make an apples-to-apples comparison between Vanguard’s 500 Index Fund and Fidelity’s Spartan 500 Index Fund, because both are tracking the same underlying index. With robo-advisor portfolios, however, every company has its own preferred funds and asset allocation formulas for each category of investor, so it is impossible to compare portfolio performance with a particular mutual fund, or with a “similar” portfolio offered by another robo-advisor platform.To make it even more difficult, most robo-advisors don’t publish performance figures for their portfolios, and those that do may have only a few years of historical data, which isn’t really enough to make an accurate comparison.That said, there are still ways to see how your robo-advisor portfolio compares. It isn’t easy and takes a bit of research, but it can be done.You can start by looking at non-advised fund portfolios with similar investment strategies. Vanguard, for example, offers a group of LifeStrategy portfolios that range from low-risk, fixed income funds with an 80/20 mix of bonds to stocks up to a more aggressive growth fund containing an 80/20 mix of stocks to bonds.Obviously, the underlying assets will be different, but you can compare your robo-advised portfolio against one of these non-advised funds and see how you’re doing. Again, it won’t be an apples-to-apples comparison, but it can give you a ballpark figure.You can also compare prices for the non-advised versus robo-advised portfolios. The Vanguard funds, for example, have an expense ratio of 0.14%, while most robo-advised portfolios will cost between 0.25% and 0.50%.On the other end of the spectrum, you can compare your robo-advisor portfolio of passively managed ETFs with an actively managed fund with similar objectives, such as the Fidelity Puritan fund, which has an expense ratio of 0.55%, slightly above most robo-advisors.Finally, you can do some very imprecise back-of-the-envelope math to give you a rough estimate of performance against a benchmark. For example, if your robo-advisor portfolio has an asset allocation of roughly 70% stocks and 30% bonds, you can choose a broad stock index such as the S&P 500 or the DJIA to represent your stock section, and a bond index such as the Bloomberg Barclays Aggregate Bond Index to represent your bond section. If the stock index has 9% gains for the year and the bond index has 2% gains for the year, an “average” 70/30 stock/bond portfolio would earn about 7% for the year. That gives you a very rough figure to benchmark your robo-advisor portfolio against.Returns are probably not the best way to compare robo-advisors, quite honestly. You’re better off comparing fees, including ETF trading fees if your robo-advisor doesn’t waive them, services such as rebalancing and tax-loss harvesting, and optional add-ons such as “advice packages” or access to a human advisor. These factors are a better indicator of whether or not a particular robo-advisor is best suited to your individual investment needs and financial situation.
The robo-advisor industry has come a long way since Betterment entered the scene in 2008. As the oldest robo, it’s not surprising that Betterment’s the largest free-standing robo-advisor in terms of assets under management ($14 billion), with Wealthfront a close second at $10 billion.The legacy firms are also fighting for a piece of the robo-pie. Charles Schwab’s no-fee Intelligent Portfolio robo manages over $33 billion, but the king of all is Vanguard’s hybrid Personal Advisor Services with over $112 billion in AUM.While investors vote with their money, AUM shouldn’t be the only—let alone defining—criterion in selecting the best robo-advisor for you. If you’re considering automated investment services, here are the factors to keep in mind when choosing a robo-advisor.

Management fees

As you’d imagine, these vary widely. Some, such as WiseBanyan and Charles Schwab Intelligent Portfolios, charge nothing to manage your money, but it’s more common to see fees in the neighborhood of 0.25% to 0.50%, or $25 to $50 per $10,000 invested.Keep in mind, though, that you may pay more than management fees when you use a robo-advisor. Most robos build ETF-based portfolios, and there may be transaction fees associated with ETF trades. Many robos waive these, however, or choose no-commission funds.And don’t forget you’ll also pay the expense ratio for any funds in your portfolio, so keep an eye on those, as well. ETFs tend to be some of the lowest passively managed investments around, but there’s still a lot of difference in long-term returns between a fund that charges 0.10% versus one that charges 0.04%.

Extra services and goodies

Tax-loss harvesting for taxable accounts and automatic portfolio rebalancing are pretty much standard with all robo-advisors, but there are other services that may be to your advantage. For example, Betterment offers fractional shares, so you don’t have to wait until you can buy a whole share in order to put your money to work. This is a nice extra if you’re on an automatic investment plan—every penny is invested right away.Wealthfront offers stock-level tax-loss harvesting for accounts that meet minimum balance requirements, which can significantly boost gains. Wealthsimple offers socially responsible portfolios so you can invest your values. These are just a few ways robo-advisors use extra services to differentiate themselves.

Account minimums

If you’re a brand-new investor, a robo with no account minimum might be the incentive you need to start saving money. On the other hand, if you’ve already got a stockpile of cash, you may be able to get into the top-rated legacies such as Vanguard ($50,000), Charles Schwab ($25,000), or Merrill Edge Guided Investing ($5,000).Most robos have low to no minimum investments, so it’s easy to get started without a lot of cash.

Investment choices

Nearly all robos build portfolios around passively managed ETFs and index funds, which are solid, low-cost options for getting broad exposure to the market. However, there are definite disadvantages in limiting your portfolio to a single asset class.Some robo-advisors include actively managed funds, individual equities, and bonds in their portfolios, while others offer asset classes you’ll rarely find in an automated service. Building Benjamins, for example, adds crypto, real estate, timberland, alternative lending, and reinsurance, among other unusual assets, to their portfolios.

Human touch and hybrid products

Some people are comfortable with hands-off digital investing, others want to know there’s a person at the end of the phone who can answer their questions and give them personal advice.Although the robo-advisor model is built around automated investment management, as the industry has evolved, more are offering access to a human financial advisor. If this is something you know you’ll want, look for a robo-advisor that makes it affordable for you to get the amount of advice you need.Betterment offers flat-fee “advice packages” built around common life events. The Marriage Planning package, for example, includes two 45-minute phone conferences with a professional advisor, the first to set up a plan, and the second six months later to monitor progress and make adjustments.Vanguard matches all its robo-advisor clients with a human financial advisor who develops a comprehensive financial plan and reviews and rebalances the portfolio to make sure it’s achieving the client’s goals. The advisor is also available by phone to provide personalized advice.Once you’ve decided to go robo, the next step is prioritizing the features and services that matter most to you. From there, it’s pretty simple to choose the one that best meets your needs.
This is a contentious issue in the financial planning world; financial advisors and fintech entrepreneurs have different opinions about the financial planning capabilities of robo-advisors.In order to honestly answer this question, it’s important to have a baseline understanding of what “financial planning” really means. Financial advisors take a holistic approach to their clients’ financial picture in order to develop a comprehensive financial plan. Traditional financial planning involves:
      • Identifying and defining financial goals, i.e. buying a home, starting a business, retiring at age 60, paying for college, and then setting benchmarks to measure progress.
      • Analyzing cash flow to see what’s available for debt, and long- and short-term saving and investing.
      • Preparing personal net worth statements and adjusting the financial plan as needed to achieve financial goals.
      • Formulating and prioritizing a comprehensive retirement strategy that includes accumulating adequate assets and planning for lifetime distributions in the most tax efficient manner.
      • Developing a comprehensive risk management plan that reduces exposure to loss, which includes recommending appropriate insurance coverage (disability, life, property, etc.).
      • Formulating a comprehensive tax reduction strategy that lowers tax liability to the extent allowed by law.
      • Developing an estate plan that preserves assets and minimizes settlement costs and taxes.
      • Identifying optimal investments and asset allocation based on financial objectives and risk profile.
     Here’s the core of the robo-advisor business model: Providing low-cost automated investment management services and creating balanced, diversified fund portfolios based on risk tolerance and time horizon. In other words, robo-advisors address a very small part of your overall financial planning needs.What they don’t do, however, is help you create realistic goals, optimize your cash flow, integrate your financial strategies, balance your overall risk, or visualize your financial picture as a whole. Those are things that require a human touch, at least given the current state of artificial intelligence, machine learning, and financial technology.Some robo-advisors do offer a larger menu of financial planning and advisor services. Betterment, for example, added a tool to account for other retirement assets, such as an employer 401(k) account, to help optimize its retirement planning services. Wealthfront adds outside accounts in its net worth projection tool. It also added Path, a tool that draws on data from the National Center of Education Statistics, to enhance its college planning capabilities. And several robo-advisors offer hybrid models, which add access to human financial advisors to the automated investment management services.Robo-advisors are a great alternative to more costly financial advisor services, especially for new investors and those with small portfolios and few assets. They provide broad exposure and portfolio diversification, along with cost-efficient investment management services.If you have a concrete goal in mind, such as accumulating a certain amount of money within a certain amount of time—buying a bigger house in five years, for example—a robo-advisor does a great job balancing risk and reward in a low-cost way for the money you’re investing toward that goal.A robo-advisor may even make sense for more mature investors with large portfolios who want to invest a chunk of their assets into a diversified portfolio of passively managed ETFs in a way that minimizes management fees. For example, if you have a financial plan that calls for investing a certain amount of money in a diversified 60/40 portfolio, a robo-advisor could manage that efficiently and inexpensively.But as a replacement for comprehensive financial planning, robo-advisors definitely fall short, at least given their current capabilities. When the next generation of super robo-advisors emerge, which promise to offer the full array of financial planning services, it may be time to revisit that conclusion.