Robo advisors have barely been around for a decade but they are growing in numbers and popularity. Robo advisors provide a valuable financial advice and investment service to young investors and investors with small accounts.
In this post we discuss exactly what robo advisors do, how you can invest with them, and the types of returns you can expect. We also look at the types of automated investing platforms, the fees they charge and factors to consider when choosing a robo advisor.
- What is a robo advisor?
- How does automated investing with robo advisors work?
- How to invest with a robo advisor
- How do you earn from investments with robo advisors?
- How much do robo advisors cost?
- Types of robo advisors
- Choosing an automated investing platform
- Pros and cons of robo advisors
- Outlook: How FinTech companies are changing the financial industry
What is a robo advisor?
A robo advisor is a digital platform that helps users save and invest toward specific goals. These platforms automate the process of asset allocation and rebalancing and primarily invest a client’s capital in passive investing products. Users typically enter details of their financial situation and investment goals into an online form. That information is then used with algorithms and models to automatically construct an investment plan. All investments are automated, and the asset mix may be adjusted over time.
Robo advisors are usually a cost-effective alternative to a financial planner or investment advisor. While automated investing is not customized to the extent that a traditional advisor arrangement may be, the lower fees offset this to a large degree. From the perspective of the financial services industry the robo advisor business model is a viable way to serve clients with smaller portfolios. Employing financial planners to advise on small portfolios is simply not scalable or feasible.
How does automated investing with robo advisors work?
Investing with an online financial advisor starts with a questionnaire which clients fill out. The questionnaire is used to gather information about the client’s current income, expected future income, expenses, risk tolerance and investment goals. This information is then processed by models to work out a suitable asset mix to achieve those goals. Automated investing platforms are based on models that use modern portfolio theory, along with historical returns and volatility data to optimize the asset allocation of each portfolio.
Once the account and portfolio are set up, the client sets up a monthly debit order to fund the plan. The remainder of the process is entirely automated. Monthly contributions are automatically invested across all the investments and portfolios are automatically rebalanced periodically. If necessary, the mix of assets may be adjusted over time to reduce volatility as a client approaches retirement age.
Clients can log into the system at any time to view their investments, account balance and their progress toward their investment goals. Apart from that, they do not have to do anything. Robo advisors usually have a specific list of investment products that they use to implement an investment plan. For the most part these will be passive investing products like ETFs (exchange traded funds).
As the industry becomes more competitive it’s likely that other types of products like hedge funds and other alternative investments will become available on these platforms. Most robo advisors also include various types of tax advantaged retirement accounts. However, the ability to move existing accounts to an automated investing platform varies from one platform to the next.
How to invest with a robo advisor
Like most FinTech platforms, automated investing companies take the user experience very seriously. Setting up a portfolio is therefore a lot easier than it typically is with a traditional investment management company. You will first need to provide all the details the platform needs to design your investment plan. Providing accurate and complete information will allow the platform to create a plan appropriate to your needs.
Investments that you already own can be transferred to the platform if they are included on the platform’s list of investable assets. In most cases it is easier to sell assets and invest the proceeds than it is to transfer them. It’s important to note that this may result in a tax liability. Some platforms allow you to transfer assets that you intend to then sell as part of a tax loss harvesting strategy.
How do you earn from investments with robo advisors?
A robo advisor portfolio generates returns from the (mostly) passive investment products they invest in. The returns and volatility will depend on which asset classes the portfolio is invested in. These portfolios should not be expected to earn excess returns, or alpha, over their benchmarks. In fact, one of the largest platforms, Wealthfront, states that they won’t beat their benchmark. Betterment, the other large US based robo advisor touts its platform as being able to outperform the average investor, rather than a benchmark.
In general, these types of platforms are aligned with the theory that most active managers underperform their benchmarks, and investors should therefore focus on earning beta (market returns) at the lowest cost possible. According to the 2019 Q1 Robo Report, US based robo advisors with track records of three years generated annualised returns of 6.4% and 8.11% over three years on their blended portfolios. Most of these platforms underperformed their benchmarks, though the magnitude was fairly small.
There are a few points to note about the returns that have been generated by robo advisors since their emergence. Firstly, they have not yet been tested by a severe bear market. Secondly, their portfolios are constructed with the long term in mind. Not only will they hold a portion in non-equity assets, but the equity investments may be more conservative than an index like the S&P 500 index. It’s therefore a little unfair to judge robo investing returns against the S&P 500 index. At the same time, investors should not expect market beating returns from these platforms.
How much do robo advisors cost?
Robo advisors charge annual management fees which are calculated as a percentage of client assets. These vary from 0 to 0.89%, with most falling between 0.25 and 0.3%. In some cases the fee varies according to the account size. The platforms that have a zero annual fee charge in other ways. Annual fees are charged on a pro-rata monthly basis.
In most (but not all) cases no commissions are charged when investments are bought or sold for a client’s portfolio. However, products like ETFs are themselves subject to annual management fees which range from 0.05% to 0.5%. There are other robo advisor fees that are charged for other services. Some platforms offer access to human advisors for an additional annual fee. Each platform is different and some charge various other fees for services such as opening or closing an account or transferring an IRA.
Types of robo advisors
The automated investing industry is still evolving rapidly, and a range of business models are being tested. The first robo advisors to launch were pure FinTech platforms that only offered an automated service. Some of these platforms have already introduced the option of speaking to a person, particularly for more complex issues like estate planning. Then there are traditional institutions like Vanguard and discount brokers like Charles Schwab that have added robo advisor services to their legacy offering. This allows clients to invest in a diversified passive portfolio while also using more traditional investment services.
Many of the newer platforms that have launched are hybrid robo advisors that try to blend the advantage of automated platforms with the human touch of traditional wealth managers and financial advisors. Automated platforms are also adding new services like estate planning, sharia compliant portfolios and other services. Increasingly platforms are adding active investing products in order to differentiate themselves.
Choosing an automated investing platform
The following are a few of the aspects of the different platforms that may be relevant to your choice of robo investing platform. If you already have capital to invest, then the required account minimum won’t be an issue. But if you are starting from a zero balance, you’ll want to look at platforms that don’t have a minimum balance requirement.
Even if your needs are fairly basic at present, you may need advice on more complex issues in the future. If you think that may be the case, it’s worth considering a platform that offers access to human advisors or financial planners.
If you have an IRA or a similar retirement savings account, you should look at whether or not you will be able to move that to a platform you are considering. It’s a lot easier to see where you stand with everything consolidated on one platform. Finally, consider whether or not you want access to other investing products like a stock portfolio, actively managed mutual funds or hedge funds. The range of products varies widely from one platform to the next.
Pros and cons of robo advisors
Automated investing comes with several obvious advantages, as well as some risks and disadvantages.
Advantages of robo advisors:
- Low costs with an asset allocation framework: Robo advisors combine the low costs of passive investing with a broader asset allocation model. Previously it was only possible to build a diversified portfolio and investment plan by using a financial advisor.
- Perfect for small portfolios and young investors: Robo advisors offer a service that wasn’t previously affordable for clients with smaller portfolios.
- Tax efficient: Investments can be made in taxable accounts as well as tax efficient retirement accounts.
- Offer other useful services: Robo advisors also offer other useful services like tax loss harvesting, estate planning and cash management.
- Remove emotion from the investing process: An overlooked aspect of automated investing is the fact that it makes it more difficult for clients to make impulsive or emotional decisions which can be damaging to a portfolio. The fact that a debit order is set up also makes it more difficult to spend rather than invest money.
- Hybrid model provides several additional advantages: By giving clients access to automated platforms as well as traditional advisors and financial planners, a more optimal balance between fees and personalised cost can be achieved.
Disadvantages and risks of robo advisors:
- Will not generate market beating returns: While robo advisors don’t promise to beat the market, they are very unlikely to beat it either. Those investors wanting to earn alpha will have to look elsewhere.
- Less personalized than traditional financial advisor portfolios: Automated platforms cannot customise portfolios to the exact needs of a client like a financial planner can.
- Dependant on information provided by a client: If the information a client provides is incorrect, this will affect the way a portfolio is constructed. In particular, a client may underestimate their risk tolerance.
- Robo-advisors remain untested: Automated platforms do not have long enough track records to be properly judged and they have not been tested by a sever bear market yet.
- No downside protection: At this stage, few if any robo advisors offer downside protection or capital guaranteed funds. This is likely to change in the future as more products are added to these platforms.
Outlook: How FinTech companies are changing the financial industry
In the coming decade we are likely to see the model evolve with new products and services being added. At the same time, FinTech is changing the way the financial planning and advice industry works, meaning traditional advisors are being forced to embrace technology as well. It’s possible that the two models will begin converging again in the future. FinTech companies are disrupting several areas of the financial services industry, and the results of this disruption will also play a part in the direction robo advisors go.
Passive investing disrupted the active investment industry, but that doesn’t mean new and improved active investment products won’t make an appearance. If quantitative funds begin to consistently outperform index funds, the playing fields will change yet again. The emergence of quantitative investing and innovative Big Data and A.I. driven funds, like the Data Intelligence Fund, makes this increasingly likely.
Robo advisors offer a valuable service to investors with smaller portfolios by providing an asset allocation framework at an affordable cost. It’s too soon to properly judge their performance or business models, and the industry is certainly still evolving. Nevertheless, these platforms are attracting new assets under management. Robo advisors are also an important step in the evolution of the investment industry, which has been slow to use technology to better meet client needs.