Technology has a way of making life easier and harder at the same time. Take investing, for example. Should you go it alone? Hire an advisor? Or use one of the many new digital investing platforms? Well, the rise of robo-advisor is here with new ways to handle digital investing. It doesn’t have to be an either/or proposition. Forward-thinking investors and advisors can harness technology to work together.
Robo-Advisors and Automated Investing Are Growing Trends
Recently, I was featured in a Consumer Reports article discussing the rise of robo-advisors and the move toward automated investing advice. Over the past few years, we’ve been hearing more and more about the potential that technology offers to make investing simpler, more rules-based and less expensive. Right now, it’s clear that the rise of automated investing is a trend that is here to stay.
An assortment of robo-advisor firms has sprouted up. Some are extensions of existing brands like Schwab and Vanguard. Others are backed by venture capital because they see the space as ripe for disruption. All-in-all, these various digital platforms have attracted more than $53 billion in investment assets. While a tiny amount compared to the more than $20 trillion invested by consumers, it is a growing trend.
I’m a fan of these algorithm- and rules-based digital investing platforms. What’s not to like? You get access to low-cost exchange-traded funds (ETFs) that provide broad global diversification. You get an allocation tied to your time horizon, goals and your risk profile. And your allocation is rebalanced automatically. All this typically without an investment minimum.
Management Fees for Robo vs. Human Advisors
The cost for all this? The robo platforms offer a fee that ranges between 0.15% and 0.4% per year, which usually covers all trading costs as well. The ETFs that are used have their own costs, but for those that use the offerings of larger brands, these generally range between 0.08% and 0.25%.
This is far less than the fees typically charged by human advisors. An investment advisor may charge between 1% and 2% of assets under management (AUM), and that's before the cost of mutual funds and trading. (For related reading, see: Fees You Can Expect From a Financial Advisor.)
Minimum Balance Often Needed to Invest
And on top of higher fees, getting access to advice can be a challenge unless you come to the table with a boatload of money. When I was working at large broker-dealer firm, the minimum required to open an account and have a relationship with an advisor was $250,000. Below this number, management considered it a waste of an advisor’s time (You could place the client in a mutual fund charging 3% to 5% in an upfront commission as an option). For a typical advisory account, the fee was about 1.5% until it was over $500,000, then it would typically drop to 1%.
And this was before adding in the cost of the mutual funds used in an account. In a pre-packaged portfolio based on a client’s risk tolerance, you would find between a dozen and two dozen mutual funds—all of the "active" variety. No individual stock. No index funds. No ETFs. And the typical costs of these active funds were about 0.80% to 1% before the underlying cost of trading the mutual fund. That could easily add another 0.25% to 0.5% per year.
So, the cost of an account where an investor delegates investment decisions to the advisor and his firm could easily top 2.25% or more per year. That’s for investment advice and hand-holding. No tax planning. No education planning. No advice or answers to non-investment questions.
Investment Fee Confusion
I recently completed a review for a retiree. He had a sizable account balance at one of the nation’s largest independent broker-dealer firms. He had all his investments in a "portfolio advisory service" containing nearly a dozen different active mutual funds. While he insisted he was paying 1% for this service, my analysis showed him—much to his surprise—that his actual cost between the advisor fee (1%), fund expenses (0.81%) and trading fees due to the fund turnover ratio (0.50%) was closer to 2.3%, or nearly $20,000 per year. You heard that right, per year. (For related reading, see: Pay Attention to Your Fund's Expense Ratio.)
His case is not unusual. The same types of programs are offered at all the major broker-dealer firms. Investors pay fees without realizing it and get investments at a cost that is far higher than other options (like index funds or ETFs) not even offered to them. This frustration and confusion is not new. Consumer Reports covered this. PBS did a Frontline special on it. And it was featured in a comically but serious way on "Last Week Tonight with John Oliver."
Compare this to the average robo-advisor that charges 0.25% and uses index ETFs that cost 0.15% to 0.25%. It’s not hard to see the appeal.
What You Don’t Get With Robo-Advisors
What do you not get with a digital investing platform? With few exceptions, you can’t hold individual stocks or bonds through these platforms. You won’t get access to closed-end funds. You won’t get advice for your 401(k) investments. And, most importantly, you won’t get financial advice or answers to non-investment or tax questions.
As I noted in the Consumer Reports article, there are some things that a computer advisor simply can’t do. It can’t help you prioritize between several financial goals (e.g. paying down debt vs. saving), navigate a tricky financial situation like a divorce, or offer advice about how to save for college or handle your elderly parents’ financial woes. (For related reading, see: What Robo-Advisors Can and Can't Do for Investors.)
The typical questions I get have nothing to do with asset allocation or investment projections. Of course, saving for retirement is important. But it’s only one of many pieces of a financial plan.
Combining Humans and Robo-Advisors for a Happy Medium
For too long, the media and public have held this misguided perception that financial planning and investing are the same thing. They’re not. And for too long, investment advisors have relied upon an AUM pricing model for their services, which almost exclusively centers on investing.
As robos clearly show, investing can be done on the cheap. And human advisors cannot really compete on price...not if they want to eat anyway. So, if human advisors insist on charging 1% or more for investment management, then God bless them because their days are numbered. If all a human advisor is doing is choosing a model developed by some outside source that uses expensive funds (active or passive) and isn't doing anything else, then what value is he or she offering?
On the other hand, robos cannot come close to providing truly customized financial planning or answer questions that have anything to do with taxes, elder care, funding education or mortgages. Notice I didn’t say investment planning. There’s more to financial planning than investing. As I’ve said in a prior blog post, robo-advisors really can’t replace human advisors, but there is room for them to work together.
By the way, that retiree paying nearly $20,000 for investment services? Using a human-digital model, he could probably save himself upwards of $15,000 per year just by shifting to a lower-cost ETF digital custodian platform. And he would still get about 18 hours of real financial and tax planning per year included from a qualified and certified professional.
(For more from this author, see: 8 Ways You Can Minimize Taxes.)