Robo advisors are becoming one of the fastest growing products within the investment landscape but what exactly are they, and what benefits do they hold for an investor in today’s marketplace?
At its core, a robo advisor is an automated online financial advisor that uses algorithms to automatically allocate, construct, manage, and optimize an investment portfolio at a fraction of the cost of a traditional advisor.
This low cost, high impact approach to investing has proved immensely popular with investors, and overall assets under management within the robo investing space are forecast to reach $2 trillion by the year 2020 according to a recent report by consultancy group A.T Kearney. Such a rapid jump in assets under management suggest that robo advisors are getting something right and in the following guide we will put some of the major features of this new way of investing through the paces, and shed some light on what these new kids on the block have to offer.
The rise in popularity of robo investing comes at a turbulent period for the wealth management industry - an industry suffering from the “profit before people“ attitude employed for much of the past two decades on Wall Street. In their quest for greater fees, many traditional advisor firms pursued a “growth at all costs” strategy - focusing all of their attention on asset gathering with scant consideration for performance.
As a result, returns at many traditional advisors have often failed to beat the broader market, prompting many to ask what value these advisors actually add. The whole process was ripe for disruption, and this new breed of Robo advisors have been attacking the advisory industry with the same gusto that other disruptors like Uber or Airbnb have accomplished to great success in both the taxi and accommodation markets.
With the entire US investment industry valued somewhere in the region of $30 trillion, the prize on offer for these firms is enormous, and individual investors will also benefit as the advisory industry morphs into a more cost effective, transparent environment where brokers have to add REAL value to earn their corn. So without further ado, let’s examine some of the key features of these robo advisors to determine if the services on offer are right for you.
True to form with their emphasis on low costs, portfolios constructed by the major robo advisor firms are comprised of established ETFs which offer liquid and cost effective access to a variety of underlying markets. Client funds are allocated according to the investor's overall risk tolerance among a diverse set of asset classes including US Stocks, US Bonds, International Stocks, International Bonds, and alternatives.
Not surprisingly, the major ETF players are over represented here with Vanguard, iShares and Charles Schwab accounting for a large portion of the underlying funds, all of which are cost effective. It’s important to note that investors will still incur fees associated with ETFs on top of the advisory fees, just as they would if they were adopting a fully DIY approach to portfolio management.
Goals and Risk
Individual asset allocations are dependent upon factors such as an investor’s overall risk profile, savings goal or time horizon. Each robo advisor firm has its own way of carrying out this assessment and typically involves an in depth questionnaire regarding an investor's current financial position and savings goals. Firms like Betterment even incorporate a retirement calculator into the process in order to establish a profile in line with an investor's objectives.
Once this profile has been established a model portfolio is constructed based on the investor’s individual profile.
A typical portfolio for an investor with a moderate tolerance for risk produces a fairly standard split between equities and fixed income although there is a good deal of variation between advisors so investors should definitely play close attention to performance histories.
Taking Charles Schwab as an example, a typical portfolio mix consists of (US Stocks: 30%, International Stocks: 30%, US Bonds: 12%, International Bonds 10%, Alternatives 19%). A similar portfolio from Betterment consists of (US Stocks: 34%, International Stocks: 36%, US Bonds: 16%, International Bonds 14%, Alternatives 0%) and WealthFront (US Stocks: 41%, International Stocks: 31%, US Bonds: 23%, International Bonds 0%, Alternatives 5%).
Providing professional and actionable advice at low cost is the bread and butter for all robo advisors and the greatest distinguishing feature compared to traditional Wall Street advisors.
Most of the top robo advisory firms charge between 0.15% and 0.5% as an annual asset management fee - a bargain compared to the 1-3% which many traditional advisors currently charge. This large disparity in fees means investors could wrack up some fairly significant savings by going down the robo advisory route - a point many industry insiders are quick to point out.
Mike Sha from SigFig estimates that a typical investor could boost annual returns by as much as $5000 per year through reduced management fees alone. Sha’s claims are relatively easy to back up - taking a real world $100,000 portfolio as an example, investors could boost returns by $2,500 alone on management fees, and stand to gain even more should they switch their execution accounts to discount players.
With increased returns of nearly 3 percent before a ball is even kicked it’s easy to see why this new breed of advisor is attracting so much attention. Use our calculator to see just how much you could save.
Unlike the traditional wealth management industry, robo advisors require extremely low account minimums to take advantage of their services - often running as low as $500.
An account of $500 would be shown the door fairly quickly at a traditional advisors office - so robo advisors have a clear edge here with their ability to provide professional actionable advice at scale offering smaller investors access to quality advice previously outwith their reach.
The passive management, or "indexing" style of investment which many of these robo investing firms employ means performance is largely tied to prevailing market conditions. Indexing is a herd style of investment which brings with it its own set of problems but also reduces the risk of both fund manager and timing bias - investors following this strategy are tying their performance to just a handful of world indices which is something investors should definitely keep in mind.
As a result, returns from the major robo advisors mirror the benchmark US equity indexes plus or minus any upside from other components of their portfolio which usually consists of ETF exposure to International stocks and bonds. An important thing to watch out for with any advisory service is the inclusion of hidden fees or portfolio requirements which could drag on return.
Some robo advisors require investors to hold a proportion of their portfolio in cash (presumably as a source of cheap funding forthe advisor) which could negatively impact returns under certain market conditions. The most extreme example we have found of this so far is at Charles Schwab who require investors to hold between 6% to 30% of their portfolio in cash depending on their stated risk tolerance. Definitely something to watch out for!
Should you use a robo advisor?
The value proposition of robo advisors is based entirely upon the quality of the underlying algorithms. By automating some of the more mundane aspects of the investment advisory industry, robo advisors provide professional and actionable investment advice at the fraction of the cost of traditional advisors. The result is a well diversified, tax efficient portfolio which conforms to an investor’s risk tolerance - something novice investors can definitely benefit from in this increasingly harsh world where most people are left to fend for themselves in preparing for retirement.
If you are a complete
beginner to investing, robo advisors offer a painless and cost effective way to get a well balanced portfolio up and running which conforms to professional portfolio theory techniques. The services on offer will also be of great value to investors with smaller account sizes who up until now have been locked out from professional advice in the traditional advisory world, and have relied largely on potluck and advice from friends as their primary investment strategy.
The benefits of robo investing are not exclusively tied to novice investors of course, experienced investors can also take advantage of some of the more complex functions robo advisors provide including tax optimization and ensuring that a their portfolios are enjoying the lowest execution fees on offer.
Tax Loss Harvesting Basics
Many of the robo advisors on offer help ensure that an investor’s portfolio is as tax efficient as possible. To accomplish this, many of the larger players offer a Tax Loss Harvesting strategy (a well known process among sophisticated investors of using investment losses to help boost after-tax returns) as part of their advisory services.
At the most basic level, tax loss harvesting is a tax deferral strategy which involves selling a security currently running at a loss and buying a correlated asset in its place to provide almost identical exposure. Through this process an investor is able to “harvest” a loss which they could then offset against future tax while ensuring the portfolio retains its optimal portfolio mix.
Effective tax loss harvesting can be a real headache if done manually but with robo advisors the process is a seamless process letting investors concentrate on investment decisions rather than complex administration. Betterment, one of the largest players in the robo advisor space, takes particular pride in its Tax Loss Harvesting strategy, claiming their service could have boosted after-tax returns by as much as 0.77% over the past 13 years for an average investor.
It's worth keeping in mind however that while tax loss harvesting is a highly effective way of offsetting capital gains tax or for sheltering up to $3,000 in ordinary income, the strategy certainly isn’t suitable for everyone. For investors in a tax bracket low enough to realize capital gains tax free, or for those investing solely in tax-sheltered accounts, then it goes without saying that they would find no need for the various robo advisors’ tax harvesting strategies.
Investors who are expecting to earn a substantially higher income in the future might also be discouraged from using the services, as the tax deferral strategy could ultimately result in more taxes in the future. So it’s important for investors to brush up fully on their current and future tax situation before committing to these types of services.
No Magic Bullet
Like almost anything in the financial sphere, robo advisors are definitely not a one stop shop for all investors - there is no one size fits all solution here and the complexity of an investor's own financial situation will largely determine how useful robo investing services will be in the long run.
While there can be no doubt of the benefit these services offer to novice investors or those just starting out, more experienced investors may still feel that robo advisors are eating too much into their potential profits. For DIY investors, it can be hard to justify paying and advisor like WealthFront a fee of 0.25% a year to create a portfolio of index securities when there are existing index funds which do the same job with far cheaper fees.
As a concrete example, an investor with a $1 million dollar portfolio with WealthFront would incur management fees of $2,500 versus $500 for the cheaper option of investing in the same underlying index fund such as Vanguard.Knowing what index funds to pick and under what circumstances and ensuring a portfolio remains optimally balanced of course is a different matter, and one which many investors are more than willing to pay for, but the cost differential is certainly something that potential investors should keep in mind.
Critics of the industry are also keen to point out that the fee structure for robo advisors still reflects too much of the old Wall Street way of doing things. The proportional fee structure whereby investors pay more as their assets increase, is one which often comes under scrutiny by those in the industry calling for true disruption. Again, these types of arguments are really splitting at hairs and many investors would be probably perfectly happy to see the amount of fees paid out to an advisor increase if it meant their assets were growing.
Sure these fees can rack up overtime and reducing them would certainly speed up the time required for an investor’s ultimate saving goal, but most investors are just looking for a solid, reliable service with which to grow their wealth for retirement and Robo advisors in this instance certainly fit the bill. By no means are any of the advisors on offer are perfect, but the niche investment services which they currently cater to are relevant, and they do them extremely well.
If you have weighed up all the pros and cons of robo advisors and wish to proceed then you will need to select an advisor most suitable to your own particular set of circumstances.
Trawling the various features each firm offers is a fairly tedious task so we have set up an easy to use comparison tool which should help get you on your way. After submitting just a few pieces of information, our in depth robo advisor comparison tool will scan through our comprehensive industry database, helping you find a suitable advisor which meets your needs.
Remember there is no one size fits all solution when it comes to robo advisors so it’s important to narrow down your search to the features which are most important to you personally. Some of the most important factors to consider include fees, minimum deposit, tax loss harvesting, and perhaps the ability to contact a human advisor should you wish to do so. For a complete rundown, check out our comparison tool above.
The Future of Robo Advisors
Love them or hate them, robo advisors are here to stay. The low cost, passive investment strategy which these advisors promote are fast becoming the prefered option for many investors, especially among millennials who have been quick to take advantage of the low account minimums.
The latest industry data from Bloomberg shows that passively managed stock mutual funds and ETFs gathered $257 billion worth of assets in 2015 compared to redemptions of $108 billion at actively managed funds. Of this figure, pure robo advisors are estimated to control roughly $50 billion worth of assets as of 2015 although the inclusion of hybrid firms pushes this number much higher.
The scale of this shift is unprecedented and is likely to increase further as more firms enter the robo advisory space in the near future. Major banks including Morgan Stanley, Wells Fargo and Bank of America have already announced plans for robo investing platforms which will likely drive fees down even lower as the battle for market share heats up.
On balance, robo advisors certainly won’t be to everyone’s liking, but few could argue that this new breed of advisor truly excels at constructing portfolios for the novice end of the market - something which would have been completely out of reach only a few short years ago. It’s clear that the old ways of shearing investors with high fees in return for a monthly or quarterly statement with no value added are gone. Going forward advisors will have to add real value to justify their services and that can only be a good thing.