Over the last decade, a number of technology-based improvements have been brought to the financial services industry, including integrated mobile payment solutions, crowd-based lending platforms and automated wealth management. While each new entrant to the financial technology arena has its merits, one of the most promising for investors is the creation of the robo-adviser – an algorithm-based, automated portfolio management system designed to meet the needs of a diverse group of investors.

How Do Robo-Advisers Work?

Robo-advisers offer investors a low-cost alternative to the traditional financial adviser experience. Through a Web-based interface, investors access portfolio management tools and asset allocation suggestions based on investment time frame and individual risk tolerance. Robo-advisers utilize an algorithm to determine the best allocation for an investor's assets based on the fundamentals of modern portfolio theory. While not all robo-advisers are the same in terms of fees charged to the investor, each platform offers a diverse group of low-cost passively managed index funds in which investors can place their money.

The greatest benefit to using a robo-adviser is the low cost structure that is a result of the no-frills mantra of servicing firms. Within the majority of these platforms, no human element is added to the investment experience, making minimums far less than those set by conventional financial advisory firms. Wealthfront, for instance, offers investment accounts to individuals with as little as $500, and includes services such as tax-loss harvesting and periodic rebalancing. For the first $10,000 invested, Wealthfront does not assess an advisory fee; accounts over this threshold cost an investor 25 basis points (0.25%) per year. Similarly, Betterment, another major player in the robo-adviser space, offers accounts with no minimum balance, asset allocation in passive exchange-traded funds (ETFs) and an annual fee of 15 to 35 basis points (0.15 to 0.35%) depending on account size. Investors seeking a long-term approach to wealth accumulation can benefit from robo-advisers, but some are hesitant of their predicted success.

Trust in Algorithms

Firms that offer robo-adviser services to investors have experienced a great deal of success in the last three years, acquiring more than $19 billion in assets under management (AUM). The majority of robo-adviser clients are millennials, as this demographic shares a love for technology-based services and low-cost platforms. Despite this exponential growth, some analysts are skeptical of the long-term sustainability of robo-adviser firms as a stand-alone investment service.

The use of algorithms and modern portfolio theory (MPT) to determine suitable asset allocation is not a new practice. Traditional financial advisers use similar strategies in creating client portfolios for a wide range of investment objectives. However, the robo-adviser methods have yet to be tested in terms of performance during a substantial market downturn, which leaves some investors and analysts wary. As with any investment approach, robo-advisers and asset allocation algorithms do not provide a one-size-fits-all solution for all investors. Instead, these platforms offer a hands-off strategy to investors who can weather the fluctuations of index investing over the long term.

Coupling Advice with Automation

Traditional investment advisory firms have had mixed reactions to the influx of robo-advisers in an already competitive marketplace. Some expect the platforms will cause a shift in the nature of investing, especially for younger investors who expect lower fees and simple access to services. While this is inevitable, robo-advisers do not provide the same level of personalized service as conventional financial advisers in the realm of comprehensive planning, alternative investment management or complex wealth transfer tactics. For clients seeking a human touch, robo-advisers often fall short.

There is, however, synergy among conventional advisers and technology-based investment platforms that offers benefits to advisers and investors alike. Financial advisers who embrace the movement of robo-advisers can utilize companies such as Wealthfront and Betterment to ensure their younger clients' needs are met in a cost-effective way while providing an easier method to achieve suitable asset allocation and diversification without increased overhead costs. This marriage between human advisers and robo-advisers is more likely to resemble the financial advisory environment of the future, once robo-advisers have a opportunity to prove their worth as it relates to investment performance.