Robo advisors use computers and other trading algorithms to produce financial advice for clients with little to no human interaction. Investors who are turned off by the idea of traditional financial advisors charging exorbitant fees while selling products that serve their own best interests may find the robo advisor more appealing. The combination of low cost and the lack of these potential conflicts of interest are making the robo advisor option more popular.
In this article, we’ll examine how well robo advisors match up with traditional target-date funds and see if they can provide superior risk-adjusted returns.
In case you are wondering whether mutual funds are right for you, you should read about why mutual funds, in general, should be a part of your portfolio.
How Do Robo Advisors Work?
A robo advisory service typically captures information on customers’ risk preferences, saving objectives, portfolio size and other personal factors to produce a recommended portfolio of stocks, bonds, mutual funds, ETFs and other options. Robo advisors are likely more ideal for younger investors who may require less complex financial planning and may simply have a need to be set up with a risk-appropriate portfolio.
In that sense, robo advisors may be helpful for younger retirement savers – those who don’t have much in the way of savings, don’t want to pay a lot for advice and just need to be pointed in the right direction. Investors getting closer to retirement and needing more complex solutions such as tax planning and guidance for how to begin withdrawing from IRAs and 401(k)s will likely find robo advisors to be less ideal.
Betterment and Wealthfront are two of the early robo advisors, but large asset managers such as Schwab, Fidelity and Vanguard have also gotten into the game. BlackRock and Invesco have both recently acquired smaller robo advisor companies to build their presence as well.
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Where Might Robo Advisors Be a Better Option?
For the past several years, target-date funds have filled the role that robo advisors are moving into now. These funds provide a simple one-stop investment option that self-manages itself by automatically growing more conservative over time and doing so at a relatively low cost. Robo advisors offer a similar value proposition, but why might they be a better option?
Robo advisors have the ability to be more personalized. Target-date funds, as the name suggests, build a portfolio with a specific end date in mind, but they don’t take into account personal factors such as risk tolerance. For example, a young investor with 30 years until retirement and not comfortable with the stock market might be placed into a stock-heavy portfolio if choosing a target-date fund solely by the date. A robo advisor, in contrast, would take that risk aversion into account and suggest a more risk-appropriate solution.
Another reason is cost. Traditional financial advisors may charge 1-2% of the portfolio annually as a management fee. Even target-date funds carry an average expense ratio of around 0.7%. Betterment, for example, charges as little as 0.25% with no minimum balance required (although, you still have to pay the expense ratios on the underlying funds as well). If you choose ultra-low cost ETFs, you may be able to get a managed portfolio for less than 50 basis points. Plus, you may be able to upgrade to working with an actual advisor for an additional fee.
Check out our target-date funds section to familiarize yourself with this asset class and to learn more about different investing techniques.
The Limitations of Robo Advisors
Robo advisors won’t be ideal for every investor. Since a robo advisory account is designed to provide basic portfolio strategies for more novice investors, it probably won’t suit you if you’re in need of more complex estate- or tax-planning strategies. Robo advisory is designed to be a passive investment strategy held for the long term, so investors looking to trade frequently or actively oversee their accounts might find robo advisors less appealing.
Robo advisory has yet to become a significant presence in the retirement and college-planning spaces. These areas are still dominated by target-date funds, which are already considered cheap and successful options. Target-date funds are considered preferable thanks to their automatic enrollment features, ultra-low cost and easy systematic investing.
While a robo advisor can help remove the burden of overseeing a broadly diversified portfolio, it does require a degree of computer sophistication to keep track of things online and know how to make changes when needed. Consider also that robo advisory services only have a limited history with which to work, so the long-term track record of these services has yet to be established.
The Bottom Line
Robo advisors are relatively new to the financial marketplace, but they look like an interesting option to fill the gap between the traditional financial advisor hired by more affluent individuals and those just getting their feet wet. The low-cost structure looks appealing, but watch for how these relationships evolve over the longer term.