What Is a Robo-Advisor?
In 2014, Betterment launched the world's first robo-advisor with the aim of serving ordinary individuals who did not have enough assets to interest a skilled financial advisor, many of whom still require an account minimum of five- to six-figures and who charge 1% or more each year in assets under management (AUM). The solution was to take advantage of advances in both technology and market structure to offer low-cost and effective investing with extremely low opening balances.
On the technology side, the use of algorithmic trading, mobile apps, and digital signatures meant that the account-opening process no longer required reams of paperwork to be signed and that computers could execute trades without error and monitor portfolios continuously—something that financial advisors could never be able to do for more than a handful of accounts at a time.
On the market side, low-cost exchange-traded funds (ETFs) emerged as the obvious type of securities to gain broad market exposure to various assets classes, such as stocks, bonds, real estate, commodities, and treasuries. ETFs charge very low management fees (now as low as 0.20%—when the average index mutual fund levies fees of 0.75%) and trade throughout the day like stocks, providing greater transparency and liquidity. Moreover, ETF trading has become commission-free at several brokers and clearing firms. All of this allows robo-advisors to manage client money for just 0.25% annually of AUM (on average), and users can open accounts with as little a $5.
- Robo-advisors are able to automate investing strategies that optimize the ideal asset class weights in a portfolio for a given risk preference.
- Financial advisors are often more than investment managers—they are communicators, educators, planners, and coaches to their clients.
- Some traditional advisors are now offering robo-advisors-as-a-service as part of the portfolio construction and investment monitoring side of a more holistic financial planning practice
Aside from the low cost and ease of opening an account, robo-advisors also have several advantages due to their heavy reliance on technology. The first is that robo-advisors are able to automate investing strategies, such as modern portfolio theory (MPT), that optimize the ideal asset class weights in a portfolio for a given risk preference. These calculations, while doable by hand, are laborious and prone to human error. A machine, on the other hand, can optimize thousands of portfolios in an instant without mistake. Moreover, algorithms can monitor and rebalance the same thousands of portfolios in real-time when markets move and asset class weights need to be adjusted.
The same algorithmic "eye" can also provide real-time tax-loss harvesting, a tax minimization strategy which sells securities that have lost money in the market and replaces them with similar assets so that the overall portfolio structure is about the same as before, but the capital losses incurred can be used to offset capital gains elsewhere. Before algorithms like these, tax-loss harvesting was time-consuming and tricky, since a mistake could result in an illegal wash trade.
Perhaps the biggest benefit of a robo-advisor is that it is truly set-it-and-forget-it. Many people don't like to think about finances and dread their semiannual phone call with their financial advisor. Other people who are DIY-inclined trying to build their own portfolios often don't have the time, discipline, or skill to do it "right." Leaving it to the algorithms can lead to a less stressful financial life.
Financial Advisor Benefits
Of course, the main thing that is lost with a robo-advisor is the human element. Financial advisors are often more than investment managers—they are communicators, educators, planners, and coaches to their clients. Relationship-building is a core part of any financial advisor's business and is often a top criteria for clients as well. A robo-advisor, for all the fees that it saves you, will never show up at your son's baseball game, take you out to lunch, or send a condolence card.
With a robo-advisor, account opening often involves a quick risk-profiling questionnaire and inputting some personal information. A traditional financial advisor instead typically begins with a personal meeting between client and advisor, with the advisor's goal of getting to know you. The advisor looks to understand why you're investing as well as tries to grasp your short-, medium-, and long-range goals. The advisor learns your risk tolerance, helps you set goals, and develops a personalized plan. The advisor then recommends investments and tactics that he or she hopes to fit with your goals.
Being on-call to answer questions, provide personalized advice, and to capture a broad swath of knowledge—from investments to tax and estate planning to insurance—is a valuable resource. This human touch, however, comes with extra cost, but it's a cost that many people find valuable and are willing to pay for.
Financial Advisor-Algorithm Hybrids
That said, several robo-advisors now do have financial advisors on-call to answer questions and provide assurances. However, unlike traditional financial advisors, many of the financial advisors hired by robo-advisors are unable to make specific investment recommendations or alter the client's portfolio weights—those are governed by the algorithm.
On the other end of things, traditional advisors are now offering robo-advisors-as-a-service as part of the portfolio construction and investment monitoring side of a more holistic financial planning practice. These tools are often white-labeled offerings from robo-advisor providers, such as Betterment or E*Trade, that are geared specifically toward advisors.
The Bottom Line
So, should you fire your advisor and switch to an algorithm? It all depends. For younger investors who may not have a lot of money to put into the markets, the low-cost and technology advantages of robo-advisors can be attractive. As digital natives, perhaps the lack of human interaction is prized rather than admonished. For older, wealthier, or technology-averse investors, a financial advisor will provide more personalized service, a greater breadth of financial advice, and a real person-to-person relationship in many cases. Although financial advisors are more expensive and require larger starting amounts, and even though humans are prone to mistakes and implicit biases and errors, those costs and even those fallibilities can provide both value and solace. In the end, perhaps a hybrid approach is best—combining desirable aspects from each.