Two of the growing trends in personal investing are the use of robo-advisors and passively managed funds. Both services benefit small investors. A market environment is evolving that ends the need to make a choice between the two.

What Is a Passively Managed Fund?

Passively managed funds are known as index funds. The central theory of index funds is based on the inability of most active investment managers to exceed the performance of market averages--as expressed by indexes--over extended periods of time. Actively managed funds charge fees based on the expense of research and the transaction costs for picking winners out of the universe of stocks.

Passively managed funds do not attempt to pick winners and losers. Instead, the fund invests in all stocks in a chosen index, in direct relation to the individual securities weighting in the average. An investor in a Standard & Poor’s (S&P) 500 Index fund owns a small portion of each of the 500 companies that form the index. The fund's return matches the index's return minus expense fees. One of the advantages of index funds is that computers handle most of the passive management work, enabling significantly lower fees.

Index funds, first offered as mutual funds, comprise the majority of all exchange-traded funds (ETFs). Passively managed funds are steadily increasing in popularity. In June 2016, investors withdrew $30.2 billion from active funds, while adding $29.2 billion to passive funds.

What Is a Robo-Advisor?

Robo-advisors are a phenomenon of the internet age. Fintech entrepreneurs created services based on the computerized algorithms used by wealth managers to determine the asset allocation of clients' investments. Investors pay a small percentage of assets – 0.15 to 0.5% – instead of the hourly rates, commissions or higher asset fees charged by personal advisors.

The investor fills out a questionnaire regarding risk tolerance, assets and financial goals. The robo-advisor algorithm picks a portfolio suite for the client and invests the money. The robo-advisor even performs periodic rebalancing to adjust for varying rates of return within the portfolio. This system is ideal for investors without complicated financial needs.

Robo-Advisors vs. Passively Managed Funds

Robo-advisors are good for people who do not want to be bothered by any of the details and just want to have their investments handled on autopilot. They do not lose the benefits of passively managed funds; robo-advisors use passively managed funds from large financial firms for investor portfolios.

Investing directly in passively managed funds is simple, as is periodically rebalancing a portfolio. An investor with even a small amount of financial knowledge can save the extra layer of fees and annually save $2 to $5 per $1,000 invested.

Direct investors are the beneficiaries of changes in the robo-advisor business.

A New Playing Field

The growth of the robo-advisor business has not gone unnoticed by the large financial firms. Wells Fargo & Co. ( WFC) announced a new robo-advisor service to start in 2017, and Wells Fargo is late to the game. Asset managers Vanguard Group, Fidelity Investments and The Charles Schwab Corp. (SCHW) already offer robo-advisor services; other large firms, such as the Goldman Sachs Group Inc. (GS) and BlackRock Inc. (BLK), will also enter the field soon.

Many robo-advisor firms will not survive in a highly competitive environment. The small fees require an enormous asset base to generate the revenue needed to run a company. The large financial firms produce multiple sources of income from clients, including the expense fees on the ETFs in the accounts. As such, they do not need to profit from the digital services. Fidelity already intends to include the fund expense ratio as part of the overall account fee. Charles Schwab is using its group of more than 50 ETFs covering many asset classes, and it is not charging any fees other than the ETFs' standard expenses.

Now that one large company offers the service for free, other companies are sure to follow; asset and client acquisition is more valuable than a small, additional fee. This is a great development for investors, but it is a dangerous trend for standalone robo-advisory services.

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