robo advisory

One of the biggest recent developments in the world of finance and investing is the growth of robo-advisors. Robo-advisors claim to provide personalized service akin to human financial advisors, helping you determine your needs, risk profile, and asset allocation. Once you’ve provided the requisite information the program takes care of the rest, automatically investing your money and any future deposits, handling the rebalancing, and more.

Robo-Advisors are targeted at people who don’t want to worry about their investments but don’t want to pay huge fees to have someone fully manage their portfolio. Some also offer additional services to maximize your returns.

While the fees charged by Robo-Advisory services are reasonable the service they provide does not always justify the price. Each individual investor’s situation will determine the value that a robo-advisor can provide.

How do Robo-Advisors Work?

Robo-advisors tout the fact that they can provide the personalized service of a human financial advisor at a lower cost and without requiring that you meet with someone in person. The first step to signing up for a robo-advisory service is for the program to assess your willingness to accept investment risk. You fill out a survey and answer questions about your assets, income, plans for the money, and how you would react in different situations. The program will then determine an asset allocation based on your answers.

If you want to see a survey in action, as well as the resulting asset allocation, Wealthfront lets you take the survey without signing up.

Once you’ve answered the survey and made your deposit, the program will automatically invest the funds the match the asset allocation it devised for you. Whenever you add more money or the allocation gets thrown out of whack by market movements the program will rebalance your portfolio. This completely removes the need for customers to watch their investments, determine where to put newly invested money, or decide when to rebalance. It also makes it easier for people to stay invested during downturns since they won’t need to follow their portfolio as closely and might not notice the size of the paper losses they are incurring.

Most robo-advisors keep fees low and work to track the market by creating a portfolio of low-cost ETFs from companies like Vanguard or iShares. This strategy means that even people with small balances can be widely diversified, holding a stake in thousands of companies.

If you set up automatic deposits with your robo-advisory service it can be the perfect set it and forget it way to invest your money. The program will take care of every aspect of investing, leaving you to decide only when to invest and when to withdraw your funds.

What Fees Do They Charge?

Robo-advisory companies make money by charging a fee for the services that they provide. Fees vary widely across the industry but tend to follow the same pattern of charging a percentage of funds annually. Wealthfront, for example, manages your first $10,000 for free but charges .25 percent a year for balances above that amount. Betterment has three tiers, charging .35 percent for balances under $10,000, .25 percent for balances under $100,000, and .15 percent for accounts over $100,000. Stash is perhaps the simplest, requiring a flat $5 to set up an account and offering free guides to investment.

The other fee that comes with using some robo-advisors is the expense ratio of the funds or ETFs that your money is invested in. Mutual funds and ETFs charge a percentage of your money annually for the service of providing easy diversification. This money is not collected by the robo-advisory service and is minimized by their use of low-cost funds, but it is a cost worth noting.

When Is a Robo-Advisor Worth the Cost?

Robo-advisors claim that they provide an array of benefits and services that would be too difficult or time-consuming for consumers to do on their own. In some cases this is true, but people with small balances are likely to find that the benefits of the services provided are outstripped by the cost of the service.

One of the most common services that robo-advisors tout is automatic tax-loss harvesting. When you sell an investment at a loss, you are able to claim the lost money as a deduction on your taxes. Tax-loss harvesting is the process of selling some of your investments when they are below the price you purchased them at, and reinvesting the money in a fund that acts similarly to the one you used to own. There are rules regarding how soon after making a sale you can make the purchase. The regulations also affect what you can reinvest the money in without it being considered a “wash sale” and ineligible for a tax deduction.

In all, you can deduct the full amount of your losses against gains from other investments. If your losses outstrip your gains, you can deduct up to $3,000 off of your regular income. Any additional losses can be carried over and used for deductions in future years. This makes tax-loss harvesting a powerful tool for reducing your total tax bill. Betterment claims that an account with a $50,000 starting balance will see an extra $45,000 in returns over thirteen years when compared to accounts without their tax-loss harvesting service.

One major caveat is that tax-loss harvesting only works for taxable investment accounts. If you are planning to use a robo-advisor for your retirement accounts, they will not do any tax-loss harvesting but will charge the same fees.

The diversification that robo-advisors provide easy to replicate for consumers thanks to the rise of index, and target date funds. The survey that you take when opening an account at a robo-advisor helps it determine the proper asset allocations for your goal. Over the years, the robo-advisor automatically rebalances and changes the allocation. For example, as you draw near your retirement date, it will invest more money in bonds to reduce volatility.

A number of companies, including Fidelity, T. Rowe Price, Vanguard, and Blackrock offer target date funds that do roughly the same thing as a robo-advisor. The fund has a target year at which it expects you to need the money for your goal. So, if you planned to retire in 2050, you would want to invest in a target date 2050 fund. If you invest your money in the fund now, it will allocate the money more aggressively, putting more in stocks than in bonds. When you invest more in the fund it will automatically distribute the funds to maintain the allocation. As the target year draws closer, the allocation will become more bond focused.

Target date funds provide less personalized service than a robo-advisor but accomplish roughly the same thing when it comes to regular rebalancing and maintaining an asset allocation over the years.

Robo-advisors do provide value, but they provide the most value to clients with large taxable accounts and complex goals that are not suited to a simple target date fund. People who are simply saving for retirement or who don’t have huge balances in taxable accounts will find that the benefits are offset by the fees.

Looking to the Future

Regardless of whether a robo-advisor is right for you, there is no doubt that the industry is booming. Some estimates have shown that robo-advisors will have more than $2 trillion in assets under management by 2020. Whether their massive growth will have any impact on the market or create competition that forces costs lower has yet to be seen.

Traditional investment companies clearly see robo-advisors as a threat. Vanguard cut the account minimum for its personal advisory service by 90 percent, dropping it to $50,000, Schwab rolled out their own robo-advisor, and other companies have sought to emulate the success of robo-advisors.

Despite their success, some are still wary of robo-advisors and the biggest challenge that they will face is one of trust. It can be difficult for investors to keep saving during a market downturn. A face to face meeting with a human advisor can be a good way to create a relationship of trust and keep people from pulling out of the market. When people are trusting a computer program to invest for them, they won’t have a human to reassure them that continuing to save is the best choice. The next major downturn in the market will be telling for the future of robo-advisors since it will be the first one that they face.

The other major challenge facing robo-advisors is a lack of differentiation. Most, if not all, robo-advisors adhere to modern portfolio theory. This leaves them little room for creativity and innovation. This means that the main difference between each company’s service is the user interface, fees, and the add-on services. Each company will come to roughly the same conclusion regarding the proper asset allocation and rebalancing for an individual.

Robo-advisors have made a splash in the world of investing and their services provide great value to some customers. People with small balances and simpler needs may be better served by target date funds.

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