A robo-advisor is a type of financial advisory firm that delivers its services through software systems. Robo-advisors provide financial advice and investment management based on mathematical and statistical models with little to no human intervention.
Robo-advisors have managed to transform the industry even though they’ve only been around for a little over a decade.
In this post, we’ll discuss how they work, their services, and how they compare to human financial advisors. We’ll also see how robo-advisors have handled the market volatility of 2020.
How Robo-Advisors Work
Over the last decade, robo-advisors have become a booming industry. Their streamlined portfolio management services have transformed the industry with their low fees, ease of use, and dramatically lower minimum investment requirements. To understand this new segment of investment management, we first need to know how robo-advisors work.
Robo-advisors use software and computer algorithms to invest clients’ money. When you invest with a robo-advisor, you typically answer a series of questions relating to your current financial situation, risk tolerance, financial goals, etc. The robo-advisor creates a suggested portfolio based on this information, typically made up of various exchange-traded funds (ETFs).
One of the most appealing aspects of robo-advisors is that once your money is invested, ongoing monitoring of your account is entirely automated; you don’t need to make any investing decisions. You don’t even need to log into your account. The robo-advisor handles almost all ongoing portfolio management.
Another big draw of robo-advisors, for many investors, is that an algorithm chooses your investments instead of a person. Many investors find this preferable since they believe it limits the amount of human error inherent in investment picking. While this may be true to a certain extent, just because robo-advisors base their investment decisions on algorithms does not mean they eliminate human error. Robots may make the decisions, but humans are still the ones creating both the technology and the algorithms that power robo-advisors.
The History of Robo-Advisors
The beginning of robo-advisors was more of an evolution than the instantaneous explosion it appears to be from the outside.
Beginning in the early 2000s, financial advisors were using software to allocate assets and manage portfolios. The only significant difference between this technology and the first robo-advisors was who had access to it. In the early 2000s, individual investors had to hire a human financial advisor to gain access. The first company to offer the service directly to investors, and therefore create the concept of the modern-day robo-advisor, was Betterment. Betterment was established in 2008 but didn’t begin working with investors until 2010.
Betterment’s success lay in the convergence of a few timely factors.
First, the financial crisis of 2008 left many in need of low-cost investment options, which robo-advisors provided. The financial crisis also caused the public to lose faith in Wall Street. The public perceived robo-advisors as a disruptor in the industry and as having less connection to Wall Street, which the public blamed for the financial crisis. Finally, millennials, who had grown up with technology, had recently begun entering the workforce. These millennials felt more comfortable with technology than their older counterparts. They were starting to have money to invest, though not nearly enough to meet the minimums required by the standard human advisor. This convergence of events made it the perfect time for robo-advisors to flourish.
Since Betterment began offering investors access to robo-advisors in 2010, the industry has exploded. Investors now have over 100 options for robo-advisors and assets under management (AUM) continue to rise. By 2015, robo-advisor AUM had reached $47.3 billion. By the end of 2016, AUM had more than doubled, reaching $98.5 billion. And the numbers only continue to rise. By the end of 2022, estimates show AUM reaching $4 trillion.
Fueling robo-advisors continued popularity is that they often have far lower fees than standard human advisors. A human financial advisor typically charges around 1% of AUM. The exact amount you’ll pay for a robo-advisor varies depending on which robo-advisor you choose and sometimes how much you have to invest. Still, it’s usually only a fraction of what a human advisor would charge.
The difference between 1% and a fraction of 1% may not sound big enough to disrupt an entire industry, but the long-term gap between these two may be more significant than you think. What’s important to consider when comparing fees is how their impact can multiply over time. The more you pay in fees, the less you have invested, and the harder it is to compound your money. Let’s look at an example to highlight just how enormous the impact of fees can be.
Let’s say you invest $25,000 when you’re thirty-five. You plan to use this money for retirement when you’re 65, which means you leave it invested for 30 years. If your average annual rate of return is 7%, and you pay an annual 1% fee, you’ll end up paying $49,537 in fees on a portfolio with a final value (after expenses) of $140,770. This comes out to a 26% reduction in the value of your portfolio due to fees.
Now, let’s say you invested that $25,000 for thirty years and also had an annual average return of 7%, but you only paid 0.25% in fees. Now, instead of a final portfolio value of $140,770, you’ll have a final portfolio value of $176,539. That’s a difference of $35,769, all because of a 0.75% difference in your fee.
As you can see, small differences in fees can have significant implications for your portfolio’s long-term health. The question now becomes, do human advisors add enough value to offset the cost of their fees?
Though this question sounds simple enough, part of the problem lies in lumping all robo-advisors and all human advisors together. Some human advisors who actively manage portfolios have a terrible track record, while others have a track record that considerably outperforms the market. Similarly, not all robo-advisors have the same performance track record. Therefore, though you’ll find plenty of claims supporting one argument or the other, it’s impossible to draw a conclusion that applies across the board.
That being said, one area that often impacts performance more than many investors realize, is the level of human interaction.
Robo-Advisors and Their Lack of Human Interaction
A human financial advisor may provide more value to clients than simply picking investments. Arguably, one of the most valuable characteristics of financial advisors is that they help clients handle one of the riskiest aspects of investing: emotion. For example, during a downturn or time of high market volatility, investors may feel the desire to remove themselves from the market altogether. While this makes sense on an emotional level, it often leads to investors selling when prices are low and buying when prices are high, which is the opposite of a successful investing strategy. As demonstrated in ETF fund flows, going against the crowd is often the best bet.
When investors feel tempted to make emotion-based investing decisions, having a trusted financial advisor they can talk to may mean the difference between making a sound investment decision or an emotion-based decision that negatively impacts their portfolio.
While it’s becoming increasingly common for robo-advisors to provide clients with the ability to speak with a person and ask specific questions, this rarely provides the same personal connection as an ongoing relationship with a human advisor. It’s often the quality of this relationship that creates enough trust for a client to listen to the advisor’s advice and avoid making detrimental emotional decisions.
Robo-Advisors and Diversification
Another reason robo-advisors have become so popular is that they give even the most novice investors the ability to diversify their portfolio, regardless of their level of capital.
Diversification is one of the most basic rules of investing since it helps minimize risk. The problem is that diversification through individual stocks is expensive. A single share of a company may be tens, hundreds, or even thousands of dollars.
Even if you have the funds available to create a diversified portfolio by purchasing individual stocks, you still need the knowledge and experience to pick equities diversified across sectors, geographic locations, market cap, etc. But funds allow anyone to create a more diversified portfolio, regardless of available capital and level of experience. The type of fund most robo-advisors use is the ETF.
An ETF is traded on an exchange, just like stock, but it is made up of a collection of securities. When you purchase one share of an ETF, you’re typically investing in hundreds of different stocks. Any investor may find an ETF to be a valuable investment, but the target customer of most robo-advisors may find them especially appealing.
Though the popularity of robo-advisors has led to offerings that target a wide range of customers, the industry is still built around serving those the investment service industry previously excluded - younger investors with less investable assets, who lack the experience or desire to manage their portfolio. Since ETFs provide an opportunity for those with less access to capital to create a diversified portfolio, they meet the needs of the typical robo-advisor customer.
But robo-advisors’ reliance on ETFs is a double-edged sword.
ETFs have been at the heart of robo-advisors’ success, but reliance on ETFs means robo-advisors lack many other investment choices. Robo-advisors offer investors access to a large number of securities through ETFs, but this is not the same as direct access to an individual stock. While some exceptions exist, in general, robo-advisors have few options for individual securities. This focus on ETFs is not innately good or bad but instead depends on your investing goals. If you’re interested in expanding your portfolio beyond ETFs, you may have difficulty doing so with a robo-advisor.
The Robo-Advisor Financial Model
As previously mentioned, robo-advisors meet the needs of people the investment services industry has historically overlooked. Robo-advisors can cater to this market, because they operate using a different financial model. To see what we mean by this, let’s compare the financial model of a typical human financial advisor and a robo-advisor.
Human financial advisors typically make their money by charging a percent of AUM. Therefore, the higher the AUM, the more the advisor makes. Many financial advisors have minimum investment requirements of hundreds of thousands or even millions of dollars. While this may sound excessive, let’s consider the math.
Let’s say you invest $10,000. If an advisor charges a 1% fee, the advisor makes $100 a year in managing your portfolio. This management includes ongoing portfolio management, in-person meetings, ongoing correspondence, etc. If the advisor wanted to make $50,000, she would need to have 500 clients. Consistently managing the portfolios and relationships of this many clients simply isn’t feasible. And that number would only cover her salary, not any of the overhead expenses that come with running a business.
As you can see, the financial model for human financial advisors is reliant upon high-net-worth clients. So how do robo-advisors make money?
Robo-advisors also make money by collecting a percent of AUM, but robo-advisors can offer a far lower fee with far lower minimum investment requirements since they can handle so many more customers. The majority of the services provided by a robo-advisor are automated, and since most of the business occurs online, the overhead expenses are lower.
Ease of Use
Beyond the lower fees and required minimum investments, another differentiator of the original robo-advisors was their easy to use digital interface. While the finance industry has historically been an early adopter of technology for internal purposes, such as the portfolio management software that was the predecessor to robo-advisors, this has not always been the case for customer service technology. We can point to a couple of reasons for this.
The first is that the larger institutions, who had the resources to integrate more technology into the customer experience, were often large, established organizations. The size of these organizations meant they often lacked the nimbleness to experiment with newer technology.
The second reason the finance industry hadn’t adopted more user-friendly technology by the time Betterment came around in 2010 was due to the industry’s heavy regulation. More substantial use of technology in interactions with clients posed questions ranging from cybersecurity to portfolio suitability. In 2010, online-only portfolio management was an unexplored frontier filled with regulatory challenges. Even years after robo-advisors have become the norm, regulators still struggle with how to handle regulating them.
While robo-advisors led the way in easy to use portfolio management tools, once the success of robo-advisors became apparent, the rest of the industry quickly followed suit. Younger investors, especially, now expect user-friendly interfaces and access to online tools and resources, regardless of whether the advisor is a robo-advisor or human advisor.
Taxes and Rebalancing
Robo-advisors’ ease of use is not limited to interfaces with simple and straightforward navigation. A huge selling point of robo-advisors is that they automate aspects of two of the most crucial yet complicated tasks for the average investor: taxes and rebalancing.
Robo-advisors may decrease an investor’s tax burden through tax-loss harvesting. Tax-loss harvesting consists of selling specific securities to incur a loss to help offset capital gains. Tax-loss harvesting requires an understanding of taxes and capital gains that exceeds that of the average investor, meaning those who choose to manage their accounts may struggle to implement tax-loss harvesting. Though tax-loss harvesting is relatively complicated, it is also a process that can be automated fairly easily. Therefore, it is no surprise that tax-loss harvesting is now a standard service offered by most robo-advisors.
Robo-advisors also automagically rebalance portfolios. Rebalancing is the ongoing process of making sure a portfolio maintains an appropriate asset allocation. Why is this important?
Let’s say the target asset allocation for your portfolio is 50% bonds and 50% stocks. This asset allocation keeps you from taking on more risk accidentally. Over time, one asset class will perform better than another. For instance, if the stocks in your portfolio outperform the bonds, your portfolio could shift to 65% stocks and only 35% bonds. This new asset allocation exposes you to more risk than is appropriate for your financial situation. Rebalancing keeps this from happening by making small adjustments, so your asset allocation remains close to your ideal allocation.
Again, this process requires slightly more financial knowledge than the average person may have but is easily automated. Making it another ideal tool for robo-advisors.
Who Should and Shouldn’t Consider Robo-Advisors?
As we’ve seen, robo-advisors aren’t right for everyone, which raises the question, who is and isn’t a good fit for robo-advisors.
Robo-advisors are one of the three main investing options. The other two are self-management and working with a human financial advisor. There are a few key things to consider if you’re trying to decide which is best for you.
The first is how much money you have available to invest. Many individuals may not have the capital necessary to meet the minimum investment requirements of many human financial advisors but may want to begin investing. This leaves the options of self-management and robo-advisors.
Hand in hand with how much you have available to invest is how much you’re willing to pay in fees. As we saw, human advisors typically have the highest fees of the three options, robo-advisors are usually considerably cheaper, and the cheapest of all is self-management. Though self-managing your account may prove cheaper from a purely fee-based perspective, if you don’t know what you’re doing, you can cost yourself more money, which brings us to our next consideration.
You’ll also want to consider whether or not you have the time, experience, or desire to manage your own portfolio. As we saw, managing a portfolio consists of more than merely choosing investments. Making the most of your money requires the implementation of strategies such as tax-loss harvesting and rebalancing. If you don’t feel comfortable implementing these strategies yourself or lack the desire to do so, a robo-advisor may be a cost-effective way to take advantage of these strategies.
Finally, you should also consider the complexity of your financial situation. Robo-advisors are not financial planners, and therefore cannot create plans for more complicated financial situations. This is where human financial advisors provide the most value and where robo-advisors have difficulty competing.
Everyone’s financial situation is unique, but in general, self-management is better for those with the time, knowledge, and interest in managing their own portfolio. Robo-advisors are better for those just starting, who have relatively straightforward financial situations, and/or who want to take advantage of lower account requirements and lower fees. Finally, a human financial advisor is better for those who need more guidance, often due to a more complex financial situation.
We discussed the three main investment options, but you may have also heard of a fourth option that’s been growing in popularity: the hybrid robo-advisor. Hybrid robo-advisors combine aspects of robo-advisors and human advisors. However, the level of human interaction may vary dramatically depending on the specific service and provider.
A hybrid robo-advisor may consist of standard robo-advisor services, but with the added benefit of direct access to a person. You may find this service useful if you want the option of addressing specific questions to a person, but in general, prefer the ease of an automated portfolio. While this service has its benefits, if you’re looking into hybrid robo-advisors it’s essential to remain aware of fees.
Some advisors use hybrid robo-advisors as a way to charge higher fees. Since robo-advisors are a popular option, they offer what is essentially an add-on robo-advisor service. The problem with this concept is that if you’re already working with a human advisor, you should not need a robo-advisor, the advisor should already be doing everything a robo-advisor does. Conversely, some robo-advisors offer additional human services at a steep price increase, which may cost you as much in fees as hiring a human financial advisor.
While hybrid robo-advisors certainly have their place and may help bridge the gap between robo-advisors and human advisors, one of the most beneficial aspects of a robo-advisor is the lower fee. If you’re not paying a considerably lower fee, there’s substantially less setting them apart from a typical human advisor.
If you decide a standard robo-advisor is right for you, the next step is choosing a robo-advisor from the plethora of options.
When comparing robo-advisors, you’ll first need to decide on your priorities. Which robo-advisor is best will depend on what you’re looking for - excellent service, the lowest fees, goal-based investing, usability, educational resources, etc. Robo-advisors typically excel in one or two of these areas, though rarely all. Once you know what matters most to you, you can narrow down the field considerably.
The next thing to consider when comparing robo-advisors is account minimums. As previously mentioned, most robo-advisors have considerably lower account minimums than human advisors, but some robo-advisors do still have account minimums. For example, Wealthfront has an account minimum of $500. Account minimums aren’t necessarily a bad thing. If you were already planning to invest the required minimum amount, this has little impact on your comparison. On the other hand, if you don’t have enough available to meet the required minimum, you may be better off choosing from one of the many robo-advisors with $0 account minimums.
Finally, there are expenses to compare. Generally, the largest cost is the management fee. But that does not mean it’s the only number to consider. Depending on the robo-advisor there may be annual fees, commission fees, etc. As with any investment decision, you should take the time to make sure you understand all the associated costs and are comparing the total amount of annual expense you’ll pay and not just the management fee.
Robo-Advisors and the Coronavirus Crash
As robo-advisors have gained prominence over the last decade, one of the biggest questions surrounding their long-term success has been how they would handle a recession. Robo-advisors came of age at the beginning of one of the longest bull markets in U.S. history. Though, in general, they performed well, the concern was that performing well in a bull market is often far easier than performing well when the market is doing poorly. Therefore, the volatility of 2020 has proven to be a telling test for robo-advisors.
So, how did they do?
Again, we face the issue of lumping all robo-advisors together. A blanket statement that all robo-advisors did well or that all performed poorly can’t answer the question. Robo-advisor performance in the first quarter of 2020 varied, sometimes dramatically. Schwab fared especially poorly, while Titan Invest outperformed most other robo-advisors.
The past performance of any broker or advisor is worth considering but should never be the sole factor driving a decision. While performance outliers may highlight some of the strengths and weaknesses of certain robo-advisors, in these volatile and unprecedented times, it’s especially important to keep in mind that past performance does not guarantee future results.
The real lesson learned from the coronavirus crash is not which robo-advisor is better or worse, but instead that robo-advisors handle volatility much the way the rest of the industry does - with varying levels of success.
Robo-advisors have transformed the investment services industry and opened up investing to many who were previously priced out of the market. The impacts of this shift are still being seen, including how robo-advisors impact market volatility.
Subscribe to Analyzing Alpha
Exclusive email content that's full of value, void of hype, tailored to your interests whenever possible, never pushy, and always free.