Robo-Advisor

What Is a Robo-Advisor?

A robo-advisor (also spelled as roboadvisor) is a digital platform that provides automated, algorithm-driven financial planning and investment 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, comprehensive education, and low fees.

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.

The technology behind Betterment was nothing new. Human wealth managers had 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 that are optimized using some variant of modern portfolio theory (PMT). Typically, the account holder cannot choose which mutual funds or ETFs to invest in, or purchase individual stocks or bonds in their account.

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.

The industry has experienced explosive growth. Client assets managed by robo-advisors reached $1.64 trillion in 2022. They're expected to reach $3.19 trillion worldwide by 2027.

Other common designations for robo-advisors include "automated investment advisor," "automated investment management," and "digital advice platforms." Regardless of the name, they all refer 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 portfolios are established, robo-advisors continue to monitor them to ensure that the optimal asset class weightings are maintained, even after market moves. Robo-advisors achieve this by using rebalancing bands.

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.

The use of rebalancing bands means that, given the ±5% corridor, emerging market and domestic blue-chip holdings can fluctuate between 25% and 35%. Government bonds can fluctuate between 35% and 45%. When the weight of a holding moves outside of the allowable band, the entire portfolio is rebalanced to reflect the initial target composition.

Tax-Loss Harvesting

Another type of rebalancing commonly found with 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, a robo-advisor will automatically sell it to lock in a capital loss; simultaneously, it buys a different S&P 500 ETF.

Benefits of Robo-Advisors

The advent 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.

• Robo-advisors 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 0.5% 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.
• It takes significantly less capital to start investing when using robo-advisors. A standard baseline for minimum assets is $3,000–$5,000. One of the most popular robo-advisors, Betterment, has no account minimum for its basic offering.
• Robo-advisors are efficient. Before robo-advisors, if you wanted to execute a trade, you'd have to call or meet with 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.
• Though using a robo-advisor may limit your investment options, this can be beneficial because buying individual stocks or trying to beat the market can produce poor results. On average, ordinary investors often see better results with an indexing strategy.

Limitations of Robo-Advisors

• Many in the industry have doubts about the viability of digital advisors as a one-size-fits-all solution to wealth management.
• Given their current technological capabilities and minimal human presence, robo-advisors have been criticized for lacking empathy and sophistication.
• Robo-advisors are good entry-level options if you have a small account and limited investment experience. You may find them lacking if you need services like estate planning, complicated tax management, trust fund administration, and retirement planning.
• Automated services are also ill-equipped to deal with unexpected crises or extraordinary situations. For example, robo-advisors will not know if you're between jobs or dealing with an unexpected expense—your funds could be drained unexpectedly by automatic withdrawals.
• 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.
• Robo-advisors operate on the assumption that you have defined goals and a clear understanding of your financial circumstances, investment concepts, and potential investment outcomes. For many investors, that is not the case.

Hiring a Robo-Advisor

Opening a robo-advisor account usually entails completing 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.

A feature of automated advisory services is their ease of online access. Many digital platforms target and attract certain demographics more than others. These include Millennial and Generation X investors who are technology-savvy and still accumulating their investable assets.

This population is much more comfortable sharing personal information online and entrusting technology with essential tasks, such as wealth management. Indeed, the marketing efforts of robo-advisory firms typically 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 in the same way that you would a human advisor.

Assets managed by robo-advisors are not insured by the Federal Deposit Insurance Corporation (FDIC). That's because they are securities held for investment purposes, not bank deposits.

However, this does not necessarily mean clients are unprotected. For example, Wealthfront, a prominent robo-advisor in the U.S., is insured by the Securities Investor Protection Corporation (SIPC). As you research robo-advisors, don't forget to check on the kind of insurance each has to protect your investment.

How Robo-Advisors Get Paid

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

Another revenue stream is payment for order flow (PFOF). This payment (typically fractions of a penny per share) results from directing trade orders to a particular market maker. PFOF can potentially result in better execution prices for clients. Typically, robo-advisors bundle various trade orders together into large block orders executed just one or two times in a day.

Finally, robo-advisors can earn money by marketing targeted financial products and services to their customers, such as mortgages, credit cards, or insurance policies. This is 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, with the largest market shares. Before investing, please check with those robo-advisors of interest to you for any updated information.

Standalone Robo-Advisors

These firms are some of the 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.

Established Firms' 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.

The Bottom Line

Robo-advisors leverage advances in algorithmic trading and electronic markets to automate investment strategies for ordinary investors.

Often based on Modern Portfolio Theory (MPT), robo-advisors are able to optimize investors' risk-return tradeoff and automatically manage and rebalance their portfolios. Automation also allows for tax-loss harvesting and other strategies that were once too complex or expensive for ordinary investors.

With low fees and small minimum balances required to get started, robo-advisors may be a good choice for most long-term investors, and may be especially attractive to younger, tech-forward individuals.