It’s been more than six years since the first robo-advisor, Betterment, appeared on the investing scene. For a while, robo-advisors were the star of the show. Because they were new, yet built on proven passive index investing strategies, and because they used high technology to reduce costs, robo-advisors received lots of attention.
Now it seems the market for standalone robo-advisors may be fading. But the concept of automated investing won’t die. Instead, we’re seeing many of the existing major financial services firms add robo capabilities.
With the industry consolidating, now seems a good time to assess the benefits and costs of choosing a robo-advisor. Most importantly, is a robo-advisor — whether a standalone offering, or at an existing major player — right for you?
For starters, what do we mean by robo-advisor? For this article, I’m defining “robo-advisor” as a low-cost service that uses a computer algorithm to choose and manage an asset allocation based on your goals and risk tolerance. However, be aware that the category has been muddied by other low-cost managed entries. For example, offerings like Vanguard’s Personal Advisor Services and Fidelity Go are competitive with most robo-advisors, with fees of 0.30% and 0.35% respectively, but continue to put the emphasis on a human advisor relationship.
The robo-advisors’ value proposition hinges on three main features: an asset allocation formula, low expenses, and automated rebalancing and tax loss harvesting. Let’s take a look…
The key feature of any robo-advisor is that it uses a computer algorithm, rather than a real-time human being, to select and manage your asset classes. But, of course, computer software is created by humans, so when you use a robo-advisor, you are still indirectly relying on other people to make key decisions about your personal finances. Most likely, it’s a committee of humans: some programmers, some financial advisors, and, often, a well-known academic added to the mix for marketing purposes. Whereas an individual advisor represents a single point of failure, with an automated robo-advisor you can be reasonably certain you are getting the best strategy from a group of experts.
A downside of most robo-advisors is that you may not be able to fully see or know the underlying assumptions. Yes, most of them furnish some sort of “white paper,” documenting the assumptions and workings of the computerized investment algorithm. But, having spent most of my career in computer software, I can vouch that written documentation seldom captures the detailed workings of a computer program. There is, frankly, an element of chance, and faith.
Another negative is the rigidity of the algorithm, however it works. Robo-advisors try to build in flexibility by asking questions about your financial situation. But they can still be a one-size-fits-all solution. What if your life doesn’t fit the programmed pattern? What if you need to modify your strategy in the short-term due to a career or location change, family emergency or inheritance, or economic developments? What if you have outlying accounts or alternative investments? There may not be room for small, tactical decisions with a robo-advisor.
The great convenience of a robo-advisor, like an all-in-one mutual fund, is that your contributions and withdrawals are automatically balanced according to your target asset allocation. You don’t have an investing decision to make every time you add or remove money from your account.
The more aggressive robo-advisor companies may try to suggest their computer algorithm offers superior performance. Others may simply argue that their rebalancing or tax loss harvesting algorithms are more sophisticated.
As with all claims of investment performance, it is impossible to verify future returns. It’s more realistic to simply ensure that your prospective robo-advisor checks the boxes of a few investing fundamentals: Is the asset allocation a function of your goals and risk tolerance? Is it a passive indexing strategy? Are expenses low? If those answers are “yes,” then the robo-advisor will likely turn in superior results to any form of active management, and comparable results to other indexing strategies, over the long haul.
The original appeal of robo-advisors was their cost savings. Most, if not all, robo-advisors construct your portfolio from a stable of low-cost mutual funds and ETFs, rolling all transaction and management costs into a single low annual percentage of assets fee.
Thus, robo-advisors generally deliver “professional” management of your portfolio for a fraction of the cost of an active manager. That was, and is, a great idea. But robo-advisors are no longer the only cost-competitive option, if they ever were.
I’ve been enjoying very low investment expenses for almost two decades, with my small portfolio of self-managed mutual funds from Vanguard. I got that religion ages ago, long before robo-advisors hit the scene. If you lack the experience to choose and manage your own mutual funds or ETFs, you could pick an all-in-one fund like a target-date or balanced fund and get most of the value of a robo-advisor with similar cost and even more simplicity. And, as mentioned above, companies like Fidelity and Vanguard are now offering advising services that feature a human advisor at prices comparable to the robo-advisors.
If you do decide on a robo-advisor, note that some charge a sliding fee, a changing percentage of assets. That percentage usually decreases as total assets grow larger, though in one case it increases, to a point. So, if you are a new or small investor, you might prefer a robo that doesn’t charge more for small account sizes. If you are wealthier, you might want to ensure your robo adjusts expenses downward as a percent of your assets, as they grow.
Rebalancing/Tax Loss Harvesting
In place of active management — attempting to buy and sell stocks or asset classes to time the market — robo-advisors offer two automated services in an attempt to add value to your portfolio: rebalancing and tax loss harvesting.
Rebalancing to keep your portfolio’s asset allocation close to your target allocation can be important over very long time frames. But it’s less important than many advisors like to make out. My research shows that the value of rebalancing lies more in reducing volatility than increasing performance. Frankly, if you neglect to rebalance, but don’t panic and sell in a downturn, your portfolio will likely do just as well, maybe even better, over the very long haul.
If you’re a do-it-yourself investor, you can likely do all the rebalancing you need in the course of making routine deposits or withdrawals from your investments. In almost 20 years of serious investing, I can count on a few fingers the number of transactions I made that were purely for rebalancing purposes. Rather, I usually get all the rebalancing I need via my existing balanced fund holdings (which rebalance internally), and routine cash flow.
Automated tax loss harvesting as implemented by robo-advisors involves selling positions at a loss and reinvesting the proceeds into similar holdings. This gives you deductible investment losses, without changing your asset allocation. It’s mostly beneficial for those with higher income: I get all the free capital gains I need in the 15% tax bracket. In theory, I might still get a few hundred dollars in reduced taxes on ordinary income in a given year from automated tax loss harvesting, assuming the robo algorithms were able to find enough in losses to harvest. And maybe I would try that, if it were a simple option, but for me it’s not worth changing investments.
And there is always the possibility, if automated tax loss harvesting becomes too prevalent, that the IRS could change the wash sale rules. There seems to be little economic or social benefit to the procedure. It’s just an attempt to game the law. I wouldn’t choose where to put my money based on it.
The ranks of pure robo-advisors have been thinning. Here is a comparison of costs and features at some of the remaining major players:
|none||Vanguard, iShares||advisor: with $250K+, rebalancing, tax loss harvesting
|Schwab Intelligent Portfolios||0%||$5,000||Schwab ETFs, other ETFs, cash||advisor, rebalancing, tax loss harvesting|
|none||direct indexing||portfolio review, rebalancing, tax loss harvesting|
In general, we should be happy to see more competition in financial services. Historically, the result has been lower prices and more transparency. And robo-advisors have played a recent role in that process. But the technology is gradually being co-opted by the mainstream financial services firms. Rather than robo-advisors taking over the investing world, existing financial advisors are supplementing their offerings with the technology.
Choosing a robo-advisor wouldn’t be a mistake for most investors. But they are optimal for a relatively small group — often the tech-savvy and price-sensitive younger crowd. Those with slightly more experience could be just as well served, at an even lower price, by managing a simple do-it-yourself portfolio of low-cost passive index funds. And those with no experience at all might be comforted by hiring a human advisor — at near-robo prices — who can talk them through key investment decisions and coach them on their financial journey.
Robo-advisors are a solid choice for investors seeking low costs and modest guidance. Though not the rising star they once were, compared to high-cost active management, trying to time the market, buying complex annuity products, or not investing at all, robo-advisors are a clear win.
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