Robo-advisers have burst onto the financial scene, gathering assets at prodigious rates. These online, algorithm-based portfolio management tools perform functions previously done primarily by professional financial advisers.
Convenience and relatively low costs have helped fuel their growth. But they are not without risk. Nor are they an appropriate solution for everyone.
Many investors do not know exactly what robo-advisers do, why they might be beneficial, or what their drawbacks are.
Traditionally, if an investor was not inclined to structure and manage his own investment portfolio, he would hire a financial adviser to perform these services. The financial adviser would assess the client’s risk tolerance and gather pertinent information such as time horizons and details of the person’s financial goals.
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The adviser would generally then use a computer-based asset allocation tool to determine a portfolio structure from which they would then select specific investments. This scheme could then be managed using the program to rebalance the portfolio and monitor progress towards goals.
A fair amount of this work is relatively repetitive and lends itself quite nicely to automation.
Data about goals and risk tolerance can be readily collected via questionnaire. Implementing and rebalancing are certainly functions suitable for automation.
Some aspects of the process clearly benefit from the robo approach. But other parts? Not so much. This creates some advantages and disadvantages for the consumer.
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The Pros of Using a Robo-Adviser
The fees charged by robo-advisers tend to be significantly less than those charged by financial advisers. The low fee structure is one of robo-advising’s greatest attractions. Exact comparisons are difficult, but for a small portfolio of around $25,000, typical robo-adviser fees run at 0.5 percent or less as opposed to financial adviser fees of one to two percent for the same portfolio.
Low Account Minimums
While not all robo-advisers have low minimum account sizes, many do. Human financial advisers, meanwhile, often have explicit or nonexplicit policies of not taking small accounts.
It can be hard to find an adviser to work with if you have a small portfolio. Not a problem for the bots!
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Financial advisers have touted the advantages of professional modern portfolio theory based money management for years. Using a computer-driven algorithm with automatic rebalancing helps investors stay invested and grow toward their goals. At least, that has been the general experience when using the system through advisers. More on this in the “cons” section.
The consumer defines his or her goals, timeframes, investment, contributions, and risk tolerance. The machine takes over from there. You're not picking one fund over another and sweating out the decision — the robot has you covered.
Many robots offer advanced services as part of the basic package or for additional fees. These include things like tax-loss harvesting and goal tracking. Not everyone needs or wants these services, but for those who do, not having them could be a deal-breaker. Advantage: bot.
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But lest these wondrous black boxes seem too good to be true, it is important to know that robo-advisers have their downsides, as well.
The Cons of Using a Robo-Adviser
Lack of Personalization
Financial advisers can help clients navigate the complex relationships and trade-offs between goals. Robo-advisers just help you manage your money geared toward specifically defined goals.
Robo-advisers are one-size-fits-all machines. While they tailor your portfolio to your goals, they may not accommodate your deviations.
Some robo-advisers require a significant cash position. If you don't want a “significant cash position,” you need a different robot. Theoretically, you could fire human advisers for the same reason, but you can at least try to negotiate with them first.
Lack of Control
The robo-adviser puts you into a pool of investments, generally exchange-traded funds (ETFs). These have fees associated with them over and above the robo-adviser’s fee. They can change your allocation and your investments, generally without your permission or prior knowledge. Many do not accommodate special circumstances, although a few do. For example, if you wish to hold a minimum portion of your portfolio in individual securities, few robots want your business.
If control is your primary objective, you may wish to trade on your own through a low-cost broker like TradeKing which also offers advisory services.
Some financial advisers follow their computer algorithms without deviation, and there is a case to be made for that. These are the advisers it is easiest to replace with a robo-adviser. Some advisers bring more to the table.
They may propose, for example, that a computer recommendation of significant bond holdings is problematic in the present interest rate environment. They may have some alternatives for you to consider — perhaps some other ideas on ways to mitigate what they perceive as an unnecessary risk recommended by a computer.
Robo-advisers are powerful tools. It is important for consumers to carefully consider the specific details of any investment they consider. This is compounded when you turn over discretionary power – the robo-adviser has the ability to make decisions about buying and selling on your behalf. The Security and Exchange Commission’s Office of Investor Education and the Financial Industry Regulatory Authority have teamed up to put out a warning about electronic advice, including robo-advisers.
Informed investors who use robo-advisers can reap the benefits of professional portfolio management at a fraction of the cost. Investors with complex situations or who want to be hands-on with their investments may be better served elsewhere.
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That said, there’s one big unknown: We have yet to experience a significant down market with robo-advisers. Hopefully, they will help people stay the course and avoid rash emotional decisions. That could be their greatest contribution.