Robo-Advisor

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What Is a Robo-Advisor?

Robo-advisors are digital platforms that provide automated, algorithm-driven financial planning services with little to no human supervision. A typical robo-advisor asks questions about your financial situation and future goals through an online survey; it then uses the data to offer advice and automatically invest for you.

The best robo-advisors offer easy account setup, robust goal planning, account services, and portfolio management. Additionally, they offer security features, attentive customer service, comprehensive education, and low fees.

Key Takeaways

  • Robo-advisors are digital platforms that provide automated, algorithmic investment services with minimal human supervision.
  • They often automate and optimize passive indexing strategies based on modern portfolio theory.
  • Robo-advisors are often inexpensive and require low opening balances, making them available to retail investors.
  • They are best suited for traditional investing and are not the best options for more complex issues, such as estate planning.
  • Robo-advisors have been criticized for their lack of empathy and complexity.
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Understanding Robo-Advisors

The first robo-advisor, Betterment, launched in 2008, with the initial purpose of rebalancing assets within target-date funds. It sought to help manage passive, buy-and-hold investments through a simple online interface. In 2022, Betterment acquired Makara, a robo-advisor platform that builds and maintains cryptocurrency portfolios to expand its offerings to investors.

The technology itself was nothing new. Human wealth managers have been using automated portfolio allocation software since the early 2000s. But until Betterment launched, they were the only ones who could buy the technology, so clients had to employ a financial advisor to benefit from the innovation.

Today, most robo-advisors use passive indexing strategies optimized using some variant of modern portfolio theory (MPT). Some robo-advisors offer optimized portfolios for socially responsible investing (SRI), Halal investing, or tactical strategies that mimic hedge funds. Additionally, they can handle much more sophisticated tasks, such as tax-loss harvesting, investment selection, and retirement planning.

In 2021, the largest robo-advisor in terms of assets was Vanguard Personal Advisor Services, with $231 billion in assets under management (AUM).

The industry has experienced explosive growth; client assets managed by robo-advisors reached nearly $1 trillion in 2020, with the expectation of reaching $2.9 trillion worldwide by 2025.

Other common designations for robo-advisors include "automated investment advisor," "automated investment management," and "digital advice platforms." Regardless of the name, it all refers to fintech​ (financial technology) applications for investment management.

Portfolio Rebalancing

The majority of robo-advisors utilize modern portfolio theory (or some variant) to build passive, indexed portfolios for their users. Once established, robo-advisors continue to monitor those portfolios to ensure that the optimal asset class weightings are maintained even after markets move. Robo-advisors achieve this by using rebalancing bands.

Every asset class, or individual security, is given a target weight and a corresponding tolerance range. For example, an allocation strategy might include the requirement to hold 30% in emerging market equities, 30% in domestic blue chips, and 40% in government bonds with a corridor of ±5% for each asset class.

In the past, this type of rebalancing has been frowned upon because it can be time-consuming and generate transaction fees. However, robo-advisors are designed to do this automatically with low fees.

Using rebalancing bands means that emerging market and domestic blue-chip holdings can fluctuate between 25% and 35%, while 35% to 45% of the portfolio should be allocated to government bonds. When the weight of a holding jumps outside of the allowable band, the entire portfolio is rebalanced to reflect the initial target composition.

Another type of rebalancing commonly found in robo-advisors—and which is made cost-effective through algorithms—is tax-loss harvesting. Tax-loss harvesting is a strategy that involves selling securities at a loss to offset a capital gains tax liability in a similar security.

This strategy is typically employed to limit the recognition of short-term capital gains. Robo-advisors do this by maintaining two or more stable exchange-traded funds (ETFs) for each asset class. So, if the S&P 500 ETF loses value, it will automatically sell it to lock in a capital loss; simultaneously, it buys a different S&P 500 ETF.

Make sure your robo-advisor is programmed to select ETFs appropriately so that you avoid wash sale violations.

Benefits of Using Robo-Advisors

The main advantage of robo-advisors is that they are low-cost alternatives to traditional advisors. By eliminating human labor, online platforms can offer the same services at a fraction of the cost. Most robo-advisors charge annual flat fees of less than .5% per specific amount managed. It is much less than the typical 1% to 2% charged by a human financial planner (or more for commission-based accounts).

Robo-advisors are also more accessible. You can reach them 24/7 as long as you have an internet connection. Furthermore, it takes significantly less capital to get started, as the minimum assets required to register for an account are typically in the hundreds to thousands ($3,000–$5,000 is a standard baseline). One of the most popular robo-advisors, Betterment, has no account minimum for its standard offering.

Many human advisors prefer to take on clients with more than $100,000 in investable assets, especially those established in the field. These high-net-worth individuals need various wealth management services and can afford to pay for them.

Efficiency is another significant advantage these online platforms have. For instance, before robo-advisors, if you wanted to execute a trade, you'd have to call or physically meet a financial advisor, explain your needs, and wait for them to execute your trades. Now, you can do all of that with the click of a few buttons in the comfort of your home.

On the other hand, using a robo-advisor will limit the options that you can make as an individual investor. For example, you cannot choose which mutual funds or ETFs you are invested in, and you cannot purchase individual stocks or bonds in your account. However, this might be beneficial as buying individual stocks to try and beat the market has been shown repeatedly to produce poor results; on average, ordinary investors often see better results with an indexing strategy.

Hiring a Robo-Advisor

Opening a robo-advisor will often entail taking a short risk-profiling questionnaire and evaluating your financial situation, time horizon, and personal investment goals. In many cases, you will have the opportunity to link your bank account directly for quick and easy funding of your robo-advisory account.

The hallmark of automated advisory services is their ease of online access. But many digital platforms tend to attract and target specific demographics more than others—namely, Millennial and Generation X investors who are technology-savvy and still accumulating their investable assets.

The SEC issued a risk alert to investors in November 2021 regarding compliance issues with many robo-advisors, so it helps to keep yourself informed by checking the FINRA Investor Alerts and the SEC Division of Examination websites for information.

This population is much more comfortable sharing personal information online and entrusting technology with essential tasks, such as wealth management. Indeed, much of the marketing efforts of robo-advisory firms employ social media channels to reach these investors.

Robo-Advisors and Regulation

Robo-advisors hold the same legal status as human advisors. Accordingly, they must be registered with the U.S. Securities and Exchange Commission (SEC) and are subject to the same securities laws and regulations as traditional broker-dealers.

Most robo-advisors are members of the Financial Industry Regulatory Authority (FINRA​). You can use BrokerCheck to research robo-advisors the same way they would a human advisor.

Assets managed by robo-advisors are not insured by the Federal Deposit Insurance Corporation (FDIC), as they are securities held for investment purposes, not bank deposits. However, this does not necessarily mean clients are unprotected, as there are many other avenues by which broker-dealers can insure assets. For example, Wealthfront, another prominent robo-advisors in the U.S., is insured by the Securities Investor Protection Corporation (SIPC​).

How Robo-Advisors Make Money

The primary way that most robo-advisors earn money is through a wrap fee based on assets under management (AUM). While traditional (human) financial advisors typically charge 1% or more per year of AUM, many robo-advisors charge around just 0.25% per year per $1,000 in assets under management.

If the returns on your investments with a robo-advisor do not outweigh the total costs associated with using it, then you may be better off not using one.

In addition to the management fee, robo-advisors can make money in several other ways. One way is the interest earned on cash balances ("cash management"), which is credited to the robo-advisor instead of the client. Because many robo-advised accounts only have a small allocation of cash in their portfolios, this can only become a significant source of income, again, if they have many users.

Another revenue stream comes from payment for order flow. Typically, robo-advisors will accumulate funds that have been added from deposits, interest, and dividends; then, they bundle these together into large block orders executed at just one or two points in a day. This allows them to execute fewer trades and get more favorable terms due to the large order sizes.

Finally, robo-advisors can earn money by marketing targeted financial products and services to their customers, such as mortgages, credit cards, or insurance policies. These are often done through strategic partnerships rather than advertising networks.

The Best-in-Class Robo-Advisors

There are hundreds of robo-advisors available in the U.S. and worldwide; more of them launch every year. They all provide some combination of investment management, retirement planning, and general financial advice.

Here is a compilation of the most competitive offerings with the largest market shares.

Standalone Robo-Advisors

These firms are some of the earliest pioneers of digital advisory technology. They have the most competitive fees with low to zero account minimums. Clients with no current invested assets can start from scratch with these platforms.

Legacy Offerings of Robo-Advisors

An increasing number of financial services and asset management firms are launching robo-advisors. These platforms typically have higher fees and account minimums and are geared more toward sophisticated investors. They are convenient options for clients who already use these firms as asset custodians.

Shortcomings of Robo-Advisors

The entry of robo-advisors has broken down some of the traditional barriers between the financial services world and average consumers. Because of these online platforms, sound financial planning is now accessible to everyone, not just high-net-worth individuals.

Still, many in the industry have doubts about the viability of digital advisors as a one-size-fits-all solution to wealth management. Given the relative nascency of their technological capabilities and minimal human presence, robo-advisors have been criticized for lacking empathy and sophistication.

They are good entry-level tools if you have a small account and limited investment experience. You may find them lacking if you need advanced services like estate planning, complicated tax management, trust fund administration, and retirement planning.

Pay attention to what a robo-advisor invests in, as many are now moving away from passive index strategies and investing in more risky areas that could underperform the market.

Automated services are also ill-equipped to deal with unexpected crises or extraordinary situations. For example, they will not know if you're in-between jobs or dealing with an unexpected expense—your funds could be drained unexpectedly if you have automatic withdrawals set up for the digital advisor.

A study conducted by Investopedia and the Financial Planning Association found that consumers prefer a combination of human and technological guidance, especially when times are rough. According to the report, 40% of participants said they would not be comfortable using an automated investing platform during extreme market volatility.

Furthermore, robo-advisors operate on the assumption that you have defined goals and a clear understanding of your financial circumstances. For many investors, that is not the case. Survey questions like, "Is your risk tolerance low, moderate, or high?" assumes that you have a fundamental knowledge of investment concepts and the real-life implications of each option you choose.

What Does a Robo-Advisor Do?

Robo-advisors provide financial planning services through automated algorithms with no human intervention.

How Does a Robo-Advisor Work?

A robo-advisor works by first gathering information on a client through an online survey and then automatically investing for the client based on that data. Robo-advisors often use passive index investing strategies.

Can Robo-Advisors Make You Money?

Yes, you can make money with a robo-advisor just like you can with any other financial advisor.

Can You Lose Money With Robo-Advisors?

Yes, you can lose money with robo-advisors, particularly with rebalancing costs, fees, and tax-loss harvesting.

Do Robo-Advisors Beat the Market?

Most robo-advisors will not beat the market because they invest in a passive index strategy that seeks to replicate the market following modern portfolio theory rather than incorporating a strategy that could potentially beat it.

Article Sources

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