Robo Advisors: A Valuable Tool for All Investors
In the past, many of the following services were not readily available to consumers outside of a traditional human advisory relationship:
- Portfolio Selection and Asset Allocation
- Financial Planning Tools
- Tax Optimization
Today, however, robo advisors are using technology to democratize access to sophisticated money management tools.
Traditional advisors provide these services at premium prices, and they generally have an incentive to focus more attention on their wealthier customers. Clients with assets below a certain threshold don’t even make the cut. This bias is both profit-seeking and pragmatic. Traditional advisory work is manual and time intensive. Humans have limited bandwidth, after all, and have to make the most of it.
By contrast, many robo advisors will open accounts for customers with initial investments under $500 and charge substantially lower fees. As it turns out, many of the best practices in asset management can be automated.
To be clear, robo advisors want to compete with traditional advisors for wealthy customers as well. Time may be on their side. Thus far, robo advisors have been most attractive to a young and upwardly mobile client base. As that group matures and grows wealthier, many may stay with robos, rather than transition to a traditional human advisor.
What kind of investor finds robo advisors attractive?
Robo advisors originally targeted younger investors. As the narrative goes, they addressed an industry coverage gap that is consistent with the experience set and preferences of the millennial demographic:
- Higher levels of comfort and trust in technology-based solutions
- Diminished trust in traditional human advisors after the financial crisis of 2008-2009
- Nest eggs that are often too small to interest traditional advisors
In recent years, the robo advisors’ client base has grown to also include a broader swath of investors, from millennials to affluent Baby Boomers.
Robo advisors have an estimated $400 billion in assets under management (“AUM”). The major independent players include Betterment.com ($11 billion AUM), Wealthfront ($9.0 billion AUM), and Personal Capital ($4.3 billion AUM).
Ironically, the largest robo advisors are actually units within traditional investment firms. These include Vanguard, Schwab, and Morgan Stanley. Vanguard alone manages over $100 billion on its robo advice platform. This growth has been achieved both organically and by actively transitioning certain existing clients to their robo platform.
What about the customer experience?
There is no single business model for robo advisors. They range from fully automated platforms with technical support only (Wealthfront) to hybrids that blend robo advice with varying levels of access to financial professionals (Vanguard and Schwab). Betterment’s basic business model is automated advice, while an additional service tier provides access to a financial advisor for a higher annual fee.
How do I evaluate a robo advisor’s performance?
This is an important question—and a difficult one to answer. Robo advisors employ academically supported algorithms that allocate a customer’s strategy across a variety of assets. Furthermore, they generally employ low cost Exchange Traded Funds (ETFs) to implement those strategies. Some robo advisors have also taken aim at the many other behind-the-scenes costs of managing money.
These are all really good things.
The challenge is that there aren’t any clear benchmarks to measure how well they are accomplishing on their mission. By contrast, if you were evaluating a typical US mutual fund, you would generally compare its performance to the S&P 500.
The development of reliable benchmarks for robo advisors will be an important part of their evolution, and it would likely broaden their potential customer base.
Are robos attractive for self-directed investors?
Fundamentally, robo advice is not a do-it-yourself service. Once you have shared your risk preferences and financial information, robo advice is generally designed as a hands-off process for the consumer. Your robo-advisor will make regular decisions on asset allocation and execute portfolio rebalances based on their computer models.
That said, working with a robo advisor can offer real learning opportunities that a DIY investor can leverage for their non-robo-advised assets. These include financial planning tools, calculators, and educational materials.
What are the costs, and are they transparent?
Robo advisors generally charge between 0.25% and 0.50% annually based on assets. Given that low cost is a key selling point for them, they tend be very forthcoming about their fee regimes.
Traditional advisors, on the other hand, typically charge 1% or higher, which may be on top of higher fees embedded in their preferred investment vehicles. As one might imagine, a traditional advisor may be inclined to focus the discussion more on the value of their services rather than fee schedules.
Automated tax optimization strategies are one of the best innovations provided by some robo advisors. It is a service that plays very squarely to their strengths.
While traditional advisors are no strangers to tax optimization strategies, their strength lies in developing solutions for larger, more concentrated positions. By contrast, tax optimization for smaller, more diversified portfolios across multiple accounts can only be executed economically by using computer power.
Robo advisors generally provide these services for no additional fees. Though short-term cost savings are likely to be modest, the compounded incremental returns can meaningfully increase your portfolio value over the long term.
Robo advice is a valuable tool for investors of many stripes. Key advantages that benefit consumers include:
- Low explicit fees
- Low or zero minimum initial investments
- Modern user interfaces
- Consistency of user experience
- Operational and tax efficiency
- Customer education
Over time, it is safe to assume that most traditional investment firms will have to provide some level of robo service to remain competitive and relevant. Whether the corporate names on the door change or not, robo advice is here to stay. Consumers should be the clear winners.