What Is a Robo-Advisor?
Robo-advisors (also spelled robo-adviser or roboadvisor) are digital platforms that provide automated, algorithm-driven financial planning services with little to no human supervision. A typical robo-advisor collects information from clients about their financial situation and future goals through an online survey and then uses the data to offer advice and automatically invest client assets.
Rise of the Robo Advisors
How Robo-Advisors Work
The first robo-advisor, Betterment, launched in 2008 and started taking investor money in 2010, during the height of the Great Recession. Their initial purpose was to rebalance assets within target-date funds as a way for investors to manage passive, buy-and-hold investments through a simple online interface. The technology itself was nothing new. Human wealth managers have been using automated portfolio allocation software since the early 2000s. But until 2008, 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 put to use passive indexing strategies that are optimized using some variant of modern portfolio theory (MPT). Some robo-advisors offer optimized portfolios for socially responsible investing (SRI), Hallal investing, or tactical strategies that mimic hedge funds.
The advent of modern robo-advisors has completely changed that narrative by delivering the service straight to consumers. After a decade of development, robo-advisors are now capable of handling much more sophisticated tasks, such as tax-loss harvesting, investment selection, and retirement planning. The industry has experienced explosive growth as a result; client assets managed by robo-advisors hit $60 billion at year-end 2015 and is projected to reach US$2 trillion by 2020 and $7 trillion worldwide by 2025.
Other common designations for robo-advisors include “automated investment advisor,” “automated investment management” and “digital advice platforms.” They are all referring to the same consumer shift towards using fintech (financial technology) applications for investment management.
- Robo-advisors are digital platforms that provide automated, algorithm-driven financial planning services with little to no human supervision.
- Robo-advisors most often automate and optimize passive indexing strategies that follow mean-variance optimization.
- Robo-advisors are often very inexpensive and require very low opening balances so that nearly everybody can benefit from a robo-advisor if they choose.
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 an annual flat fee of 0.2% to 0.5% of a client’s total account balance. That compares with the typical rate of 1% to 2% charged by a human financial planner, and potentially more for commission-based accounts.
Robo-advisors are also more accessible. They are available 24/7 as long as the user has 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 ($5,000 is a standard baseline). One of the most popular robo-advisors, Betterment, has no account minimum at all.
In contrast, human advisors do not normally take on clients with less than $100,000 in investable assets, especially those who are established in the field. They prefer high-net-worth individuals who need a variety of 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 a client wanted to execute a trade, he/she would have to call or physically meet a financial advisor, explain their needs, fill out the paperwork and wait. Now, all of that can be done with the click of a few buttons in the comfort of one’s home.
On the other hand, using a roboadvisor will limit the options that you can make as an individual investor. You cannot choose which mutual funds or ETFs you are invested in, and you cannot purchase individual stocks or bonds in your account. Still, picking stocks or trying to beat the market has been shown time and again to produce poor results, on average, and ordinary investors are often better off with an indexing strategy.
Hiring A Robo-Advisor
In short, everyone with an internet connection and a bank account to fund the investments with. The hallmark of automated advisory services is their ease of online access. But many digital platforms tend to attract and target certain demographics more than others. Namely, the younger cohort of Millennial and Generation X investors who are technology-dependent and still accumulating their investable assets. This population is much more comfortable sharing personal information online and entrusting technology with important tasks, such as wealth management. Indeed, much of the marketing efforts of roboadvisory firms employ social media channels to reach Millennials.
Opening a roboadvisor will often entail taking a short risk-profiling questionnaire and an evaluation of your financial situation, time horizon, and subjective investment goals. You will have the opportunity in many cases to link your bank account directly for quick and easy funding of your roboadvisory account.
Still, the industry is garnering increasing interest from Baby Boomers and high-net-worth investors as well, especially as the technology continues to improve. Recent research by Hearts and Wallets shows half of the investors aged 53 to 64, and one-third of retirees, use digital resources to manage their finances.
Robo-Advisors and the SEC
Robo-advisors hold the same legal status as human advisors. They must register with the U.S. Securities and Exchange Commission to conduct business, and are therefore subject to the same securities laws and regulations as traditional broker-dealers. The official designation is “Registered Investment Adviser,” or RIA for short. Most robo-advisors are members of the independent regulator Financial Industry Regulatory Authority (FINRA) as well. Investors 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. This does not necessarily mean clients are unprotected however, as there are many other avenues by which broker-dealers can insure assets. For example, Wealthfront, the second-largest robo-advisor in the U.S., is insured by the Securities Investor Protection Corporation (SIPC).
The Best-In-Class Robo-Advisors
There are now over 200 robo-advisors available in the U.S., and more are launching every year. All of them provide some combination of investment management, retirement planning, and overall financial advice.
Below is a compilation of the most competitive robo offerings with the largest market shares.
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 who have 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 their own robo-advisors. These platforms typically have higher fees and account minimums and are geared more towards sophisticated investors. They are convenient options for clients who already use these firms as their 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 robos 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 in empathy and sophistication. They are good entry-level tools for people with small accounts and limited investment experience, namely Millennials, but far from sufficient for those who need advanced 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 instance, if a young person’s parents passed away and he/she receives an inheritance, going online to a robo-advisor to manage the money is probably not the optimal decision.
In fact, 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 clients have defined goals and a clear understanding of their financial circumstances, to begin with. For many, that is not the case. Answering questions like “Is your risk tolerance low, moderate or high” presupposes the user has a fundamental knowledge of investment concepts and the real-life implications of each option they choose.