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Why do robo-advisors almost always recommend ETFs?

If you use a robo-advisor to manage your money the chances are your portfolio will be filled with ETFs. Five years after Betterment launched the robo-advisor concept in 2008, nearly 100% of all assets under management were in ETFs. Today, 10 years into the robo-advisor era, more robo-advisors are tapping into other niches, including individual stocks and other asset classes such as real estate, P2P lending, and infrastructure.

These robo-advisors are a distinct minority however. The ETF is still the investment of choice in most robo-advisor portfolios. This actually aligns with the investing public as a whole; in 2010, ETFs accounted for just $800 million compared to $3 trillion by the end 2017.

There are many reasons for that. Perhaps most significantly, ETFs are inexpensive to hold. Most have expense ratios below 0.10%, and there are many that cost as little as $40 per $10,000 invested. Since low cost is a primary factor behind the success of robo-advisors, it makes sense that they would choose assets that are similarly cost effective for their clients.

Second, ETFs allow broad exposure to a particular basket of stocks or other asset classes. The ETF market is large and diverse, with funds tracking major domestic and international indices and asset classes. ETFs make it relatively easy to build a diverse portfolio.

ETFs are also more tax efficient than other mutual funds. Generally speaking, an ETF will only create a taxable event when it sells off an equity that has been removed from an index. Other structural differences between ETFs and mutual funds contribute to the overall tax efficiency. One study revealed that mutual funds generated capital gains equal to about 7% of NAV, while index funds generated just 0.02% of NAV in capital gains.

Another advantage of ETFs over other types of funds is that there are no account minimums to invest in an ETF. This aligns with many robo-advisor platforms, which require no minimum deposit to open an account. The minimum investment for an ETF is the cost of a single share.

Obviously, there are risks associated with a portfolio constructed solely of ETFs. Most robo-advisors look for the cheapest funds and overlook considerations such as tax efficiency and liquidity. Less liquid funds have larger bid-ask spreads which can affect overall performance.

Finally, most ETFs are passively managed, in that they simply seek to mimic the performance and composition of the underlying index. There is an element of tracking error inherent in the ETF model, which means that ETFs will almost always underperform the index to some degree. Although there are some actively managed ETFs that do seek to beat the market, they tend to have higher expense ratios, and as such, are rarely included in robo-advisor portfolios.

There are some robo-advisor platforms that do focus on actively managed funds in an attempt to boost returns. One is Qplum, which uses artificial intelligence to shape its trading strategies. Their Flagship Portfolio has 45 actively managed ETFs across several sectors and asset classes and has consistently outperformed the S&P 500.

The bottom line is that ETFs make sense as part of a well balanced portfolio, and they work especially well in robo-advisor portfolios aimed at small or inexperienced investors and those in the earlier stages of wealth building. But it’s also important to consider moving beyond an ETF-exclusive portfolio to reduce systemic risk, and robo-advisors who offer additional asset classes may have the advantage.