- A robo-advisor is a service that uses computer algorithms to build and manage investment portfolios, requiring little human involvement and interaction.
- Robo-advisors are popular because they provide automated strategies based on your investment goals at a much lower cost than a human financial advisor or manager.
- Robo-advisors are well-suited for novices and hands-off investors, and less-suited for investors who want more control and customised management advice.
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Robo-advisors are automated trading and investing platforms used to build and maintain financial portfolios. When first launched to the public in 2008, they were touted as a tool to bring professional money management to the masses.
Robo-advisors have grown in popularity largely because they offer users a simple and cost-effective way of investing, avoiding the need to deal with â€” and pay â€” human professionals (though they may supplement their services with live advisors).
While many of the services are overtly branded to appeal to a younger generation, research by Deutsche Bank indicates that robo-advisor clients are on average in their mid-40s.
With their low fees and deposit minimums, robo-advisors have opened up savings and investments to a new realm of investors â€” and can work for the more experienced as well. But are they right for you? Let’s take a deeper dive.
What is a robo-advisor?
Armed with artificial intelligence (AI), robo-advisors automate the process of selecting and managing investment portfolios, using algorithms and modern portfolio theory (MPT) to pick and maintain a balance of assets suited to each customer. And the technology is constantly evolving, incorporating the Nobel-prize winning research of economists like Eugene Fama and Robert Shiller into its algorithms.
Professional traders, investment managers, and brokers had actually been using robo-advisor technology since the 1980s; it’s only in recent years that companies have been marketing it directly to consumers. The first robo-advisor made available to the general public was Betterment. Launched in 2008, it now counts around $US22 billion assets under management.
Today, robo-advisors fall into two basic categories: those that are exclusively online, like Betterment and Wealthfront, and those offered by brick-and-mortar brokerages and financial service firms, from Morgan Stanley to Charles Schwab. The traditional firms tend to aim to investors with a bit more capital, often requiring higher minimum deposits and charging higher fees â€” but also the option of live interaction.
How do robo-advisors work?
Signing up for a robo-advisor service is usually a simple process, involving the completion of questionnaires intended to gauge your attitude to risk.
“An investor typically provides information about his or her risk tolerance, time horizon, and investing goals, and based upon that information, a portfolio is recommended, usually comprised of low-cost ETFs, that are managed and rebalanced as needed,” says Keith Denerstein, TD Ameritrade’s director of investment products and guidance.
While some platforms will ask only basic questions, others will pose a more detailed range of queries intended to identify the specific financial needs of the client and provide regulated advice.
“Over the past few years the ‘catch-all’ term ‘robo-advisor’ has become increasingly obsolete, with firms preferring more specific terms such as Digital Wealth Service, Automated Advice, Hybrid Advisor or even Bionic Advisor to better describe what they actually do,” says Simon Bussy, Altus’ director of wealth and an expert on the digital-advice sector.
How much do robo-advisors cost?
“The average robo advisory platform charges a management fee for its services, typically less than 0.50% per year,” says Denerstein. TD Ameritrade’s Essential Portfolios robo-advisor, for example, carries a .30% advisory fee. Vanguard’s Digital Advisor charges an annual $US4.50 a year for every $US3,000 invested.
These fees can vary, though, depending on the size of your portfolio. Vanguard’s higher-tier Personal Advisor Services, which combines robo-management with human advisors, charges fees on a sliding scale:
- .30% on $US25,000-$US5 million portfolios
- .20% on $US5-10 million portfolios
- .10% on $US10-25 million portfolios
- .05% on $US25+ million portfolios
Other robo-advisors may charge an ‘expense’ or trading fee on each transaction. There is also the fee, or expense ratio, charged by the funds the robo invests in.
But the overall cost of using a robo-advisor generally amounts to less than 1% of assets under management (AUM).
How do robo-advisors make money?
Because fees are so low, robo-advisors are increasingly making money via other revenue streams. Some, such as UK-based Wealthify and Munich’s Scalable, sell their technology to other money managers or financial professionals.
Others are looking to move beyond portfolio management, offering banking services such as high-yield savings accounts. The idea is to encourage customers to keep excess cash with the service or attract new clients.
Other robos have a hybrid model, mixing automation with humans. The more personal the advice, the higher the cost.
For example, Merrill Lynch offers a tiered investment management service. Its basic product is Merrill Edge Self-Directed Investment, a completely automated platform, which no minimum investment. It then offers online Guided Investing, for a $US5,000 minimum, which features some live customer service. And finally, there’s the top-of-the-line Guided Investing, starting at $US20,000, which combines a robo-advisor with one-on-one human portfolio management and advice.
Advantages of robo-advisors
Automated money management comes with several strong points.
They are comparatively inexpensive to human advisors
Given that they automate most (or all) of the investment process â€” and don’t eat much â€” robo-advisors generally cost a lot less than human advisors. They charge between 0.02% and 1% of investment portfolios annually, while traditional wealth managers charge between 2% and 3%, according to a Deloitte study of around 100 platforms.
They accept smaller portfolios
Robo-advisors usually have lower account requirements than traditional brokerages and investment managers. For example, Betterment has a minimum account requirement of $US0, while Wealthfront has a minimum of $US500. By comparison, Morgan Stanley’s robo-advisor has a minimum of $US5,000.
“The typical retail investor using a robo advisor can potentially benefit from professional portfolio management at a cost far lower than that traditionally charged by a [live] advisor,” says Denerstein.
They require no research or oversight
Because they do all the choosing and investing, robo-advisor platforms don’t require much on the part of investors. You need no specialised knowledge of stock markets, P/E ratios, balance sheets, or anything else. They’re truly geared to the novice or the invest-it-and-forget-it client.
Disadvantages of robo-advisors
Automated money management has its downsides as well.
You don’t have much choice or control
Robo-advisors mainly invest in inexpensive exchange-traded funds (ETFs) and index mutual funds (one way they keep costs low). But the majority of services don’t let users select which funds are included in their portfolios. Nor do they invest in individual stocks, bonds, or more exotic, alternate investments.
Your portfolio isn’t all that personalised
Robo-advisors usually apply general criteria when selecting or recommending portfolios to customers. In many cases, they shoehorn customers into one of their preexisting model portfolios (i.e., growth, income, growth + income) based on the basic risk tolerance, income profile, and rudimentary investment goals indicated in your questionnaire.
You can’t talk to them
Many robo-advisors, especially the online-only variety, don’t provide clients with a direct line to any human help. The customer service reps, if any, are mainly there for logistical questions; they don’t provide any financial counseling or explain investment strategy.
You don’t get much financial advice
While they may provide some general financial planning tools, like retirement calculators, robo-advisors aren’t financial planners. They just invest money. That means they can’t counsel you on long-term financial plans and goals, such as saving for retirement or college, or when unexpected financial needs arise.
That’s why human wealth managers and “financial planners argue that ‘robos’ cannot replace them â€” they are not sophisticated enough to understand the whole picture or provide fully-rounded advice,” says Bussy.
The financial takeaway
Whether they’re right for you or not, robo-advisors could spell the future of investing. According to the financial educational site BuyShares, the number of assets under robo management rose 178% between 2017 and 2019. It estimates these auto-advisors will be handling $US987.4 billion in total assets by the end of 2020.
Robo-advisors serve portfolios large and small, and a variety of investor types. “A low- cost ‘robo’ can help someone get their foot on the investment ladder, or for more experienced investors, can help save them costs,” as Bussy puts it.
Still, robos remain primarily of best use for hands-off investors, or those needing to start out small or cautiously on their investment journey. They’re generally not for anyone who wants a more personal touch or customised approach, a diversified mix of assets, or who feels confident enough to pick their own investments.