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What Is a Robo Advisor and How Do They Work?

min read
Robo advisors use algorithms to translate your investment risk tolerance into a diversified investment portfolio. What are the pros and cons, and how do you choose?

robo advisor dataThe robot age is here.

From drones to self-pedriving cars, machines that perform functions previously handled by humans are marching off the pages of science fiction and into reality. So if they can make a self-driving car, how about a self-driving investment program?

That idea has been reality for a few years now. Automated wealth managers, more popularly known as "Robo advisors" are here and they are growing fast, stepping into roles that have traditionally been filled by financial planners and investment advisors.

Is a Robo advisor right for you?

This guide provides information about how Robo advisors work, identifies some of the pros and cons of using Robo advisors for your investments, discusses Robo advisor fees and features, and offers 10 things to look for when choosing a Robo advisor.

How Robo advisors Work

Robo advisors use algorithms to translate your investment risk tolerance into a diversified investment portfolio. This includes both determining asset allocation and choosing individual mutual funds to populate that allocation.

Some Robo advisors also offer tools designed to help you with retirement planning. For example, if you specify a retirement income target and retirement date, the program can tell you how much you need to contribute to your IRA or 401(k) each year to meet that target.

As you may have noticed, asset allocation, security selection and retirement planning are all functions that human financial professionals perform. Can Robo advisors do it better? The results have been mixed, but conceptually there are both pros and cons to the Robo advisor approach.

Pros and Cons of Robo advisors

Robo advisors address two problems that have traditionally plagued the financial industry: cost and human error. Here's we assess the risks and benefits:

Pros

  • Lower charges

    Robo advisors offer investment management for a fraction of what human investment advisors charge. Since some investors perform above average and some perform below average, overall it is the fees that play a large role in determining how well individuals keep up with the market and make progress toward their goals.

  • Lower risk of being affected by market extremes

    As for human error, aside from the fact that some investors are more competent than others, the fact is that time and time again professional and amateur investors alike have gotten caught up in the emotion of market ups and downs. They get more aggressive during bull markets and more tentative during bear markets. A Robo advisor can smooth out those extremes, keeping your portfolio on an even keel.

Cons

  • Limited by past data

    The other side of the coin is that a Robo advisor cannot see into the future any better than a human investment professional. In fact, Robo advisors work by looking into the past rather than into the future, and that can have its limitations.

  • Market models may not be accurate

    The formulas used by Robo advisors to make decisions are based on the historical behavior of different assets. The problem is that history does not always repeat itself in a predictable manner. In particular, when bond yields are unusually low and stock valuations are unusually high, the historical risk/reward characteristics of these asset classes may not be especially relevant. That would make the type of models used by Robo advisors less effective.

Compare Robo advisors

LEARN MORE on Ally Invest's website
Ally Financial
https://www.ally.com/invest/managed-portfolios/
Ally Financial is affiliated with both a bank and a broker-dealer, but their advisory products and services are offered through Ally Invest Advisors, Inc., an SEC-Registered Investment Advisor.
  • Good for: Small investors who want some element of personalization in their investment approach.
  • Not as good for: Investors seeking a great deal of visibility as to the portfolio construction process or individual holdings.
  • Ally Financial uses third-party ETFs and other vehicles to construct a portfolio based on individual characteristics provided by the client. The client can then further customize the recommended portfolio, with additional help available from human specialists.
  • Portfolios are rebalanced to their target asset mixes automatically.
  • Ally doesn't charge an annual advisory fee for their Cash-Enhanced Managed Portfolio. Clients may incur additional charges via the expense ratios of ETFs and other vehicles Ally uses to implement its portfolio management approach.
LEARN MORE on Acorns Invest's website
Acorns
https://www.acorns.com/
The Acorns saving/investing platform is operated by Acorns Advisers, LLC, an SEC-Registered Investment Advisor.
  • Good for: Small investors who want to choose a pre-defined portfolio.
  • Not as good for: Investors seeking tools to help them match a portfolio with their goals, or a more customized investment approach.
  • Acorns allows investors to start small and accumulate money gradually. They offer participation in a range of five standard portfolios with different asset mixes ranging from conservative to aggressive.
  • Acorns provides automatic rebalancing for these portfolios, and human assistance is available.
  • For most investors, Acorns offers three tiers of service at a flat rate of $1, $2 or $3 a month. They have different pricing for portfolios of $1 million or more. The ETFs used to construct portfolios have additional management fees which vary depending on the type of fund.
LEARN MORE on AssetBuilder Invest's website
AssetBuilder
https://assetbuilder.com/
AssetBuilder, Inc., is an SEC-registered investment advisor. AssetBuilder has partnered with Dimensional Fund Advisors, a fund manager, to provide the various funds used to construct its portfolios.
  • Good for: Investors who want an automated-asset-allocation approach based on a basic risk-tolerance assessment.
  • Not as good for: Very small investors or those who want an advisor with the flexibility to choose from multiple fund families.
  • AssetBuilder offers a range of eight standard portfolios starting at 20% equity/80% fixed income and ranging up to the most aggressive version of 90% equity/10% fixed income.
  • Its website offers an easy-to-use, rudimentary tool to assess risk tolerance as a means of guiding the selection of a portfolio type. Portfolios are rebalanced automatically.
  • AssetBuilder charges clients an annual advisory fee of between 0.20% and 0.45%, depending on the account size.
  • In addition, clients incur annual charges of between 0.25% and 0.45% via the expense ratios of the funds used to construct the portfolios, along with commission expenses when portfolios are set up or the funds within them are adjusted.
LEARN MORE on Betterment Invest's website
Betterment
https://www.betterment.com/
The advisory site is operated by Betterment LLC, an SEC-registered investment advisor. Brokerage services are provided to clients of Betterment LLC by Betterment Securities, an SEC-registered broker-dealer.
  • Good for: Investors who want to combine ease of access with a degree of personalization in the construction and customization of portfolios.
  • Not as good for: Investors who want the transparency and detailed control that comes with owning individual securities.
  • Betterment uses ETFs to construct an asset mix based on their clients' investment goals. It offers tax-loss harvesting and automatic rebalancing, plus the opportunity for clients to make manual adjustments to their investment mix.
  • At the premium service level, Betterment adds the ability to coordinate your managed portfolio with outside investments to help keep your overall asset mix in line with your objectives.
  • Betterment offers two tiers of service, the first at an annual fee of 0.25% for basic automated management and the second at 0.40% which includes automated management plus access to Betterment's team of Certified Financial Planners and coordination of your Betterment portfolio with your outside investments.
  • Betterment uses ETFs which may have an additional cost via their expense ratios, but there are no commission charges on ETF trading.
LEARN MORE on Schwab Intelligent Portfolios Invest's website
Schwab Intelligent Portfolios
https://intelligent.schwab.com
The Schwab Intelligent Portfolios platform is made available through Charles Schwab & Co., Inc., a dually registered investment advisor and broker-dealer.
  • Good for: Relatively small investors and those who want to avoid paying an advisory fee on top of ETF expense ratios.
  • Not as good for: Investors who want complete independence between their advisor and the ETFs selected for their portfolios, since Schwab uses some of its own ETFs.
  • Schwab uses an asset-allocation model to develop a portfolio of ETFs based on information gleaned from a client questionnaire. Portfolios are rebalanced automatically, and tax-loss harvesting is available to larger clients.
  • Schwab charges no advisory fee, but earns money via the expense ratios of its own ETFs, some of which are used to construct the portfolios in this platform. Those expense ratios vary based on the objective of the ETF.
LEARN MORE on Ellevest Invest's website
Ellevest
https://www.ellevest.com/
Ellevest, Inc. is registered with the SEC as an investment adviser firm.
  • Good for: Investors who are interested in an investment approach geared toward women's financial needs with the opportunity to make specific investments deemed supportive of women's issues.
  • Not as good for: Investors who are not interested in a gender-specific investment approach.
  • Uses an algorithm to determine an asset allocation designed to meet stated client goals, and uses ETFs to construct a portfolio according to that target allocation. The approach is geared to specifically acknowledge certain investment characteristics of women based on differing earnings patterns and lifespans.
  • Ellevest also offers the opportunity to participate in impact-investing portfolios which are designed to make investments in companies supportive of women. Access to an Ellevest Certified Financial Planner is available to premium-level clients.
  • An annual fee of 0.25% for the basic service or 0.50% for the premium service. These fees are on top of expenses incurred via the ETFs used to construct portfolios.
LEARN MORE on FutureAdvisor Invest's website
FutureAdvisor
https://www.futureadvisor.com/
FutureAdvisor is owned by Blackrock, Inc., an investment adviser registered with the SEC.
  • Good for: Current investors who want to adopt a robo-advisor approach without relinquishing all their existing investment accounts and holdings.
  • Not as good for: Investors who want to minimize advisory fees.
  • FutureAdvisor uses an algorithm to target an asset allocation based on the client's goals, but where FutureAdvisor differs from most robo-advisors is in the ability to incorporate existing brokerage accounts and mutual funds into its asset-allocation model.
  • For individual accounts, FutureAdvisor will directly trade the holdings in those accounts in accordance with its model. For employer-sponsored accounts, FutureAdvisor can take them into consideration in its asset-allocation approach but cannot actively trade them.
  • An annual fee of 0.50%. Additional costs may be incurred via expense ratios used to construct the portfolio and commissions for trading those funds.
LEARN MORE on Hedgeable Invest's website
Hedgeable
https://www.hedgeable.com/
Hedgeable, Inc., is a Registered Investment Advisor firm with the SEC.
  • Good for: Smaller investors who crave a degree of customization generally reserved for larger investors.
  • Not as good for: Highly cost-conscious investors looking for one of the least expensive options available.
  • Hedgeable uses an algorithm to set an asset-allocation target based on client objectives and rebalances to that target automatically.
  • Hedgeable differs from most robo-advisors in that it has the capability to use individual securities in addition to ETFs and other funds. Hedgeable also offers the option of participating in social-investing options pursuant to eight different social-responsibility themes.
  • Starts at an annual fee of 0.75% for portfolios under $50,000 and scales down incrementally to 0.30% for portfolios of $1 million and up. Additional expenses may be incurred from the ETFs used in portfolio construction.
LEARN MORE on Personal Capital Invest's website
Personal Capital
https://www.personalcapital.com/
Personal Capital Advisors Corporation is an investment advisor registered with the Securities and Exchange Commission.
  • Good for: Investors wanting an automated approach that provides for an unusual degree of detailed customization.
  • Not as good for: Smaller accounts or highly cost-conscious investors looking for one of the least expensive options available.
  • Besides formulating a general asset allocation based on detailed client characteristics, they add extra levels of customization by using individual securities in addition to ETFs in portfolio construction, offering the option of social-investing filters, and incorporating outside portfolios into their tools and methodology.
  • 0.89% for portfolios under $1 million. Additional expenses may be incurred from the ETFs used in portfolio construction.
LEARN MORE on SigFig Wealth Management Invest's website
SigFig Wealth Management
https://www.sigfig.com/
SigFig Wealth Management LLC is an SEC-registered investment advisor.
  • Good for: Relatively small investors looking to get started at very low cost.
  • Not as good for: Investors interested in highly customized portfolios including individual securities as well as funds.
  • Uses an algorithm to develop an asset allocation designed to be optimal relative to the client's goals. SigFig rebalances automatically and considers several aspects of tax implications in its portfolio decisions.
  • First $10,000 is free, and the annual fee for assets above $10,000 is 0.25%. Additional expenses may be incurred from the ETFs used in portfolio construction.

How to Choose a Robo advisor

If you decide to use a Robo advisor, what is the best firm to use? That largely depends on your needs. If you work through this shopping list of ten things to look for when choosing a Robo advisor, you should have a better sense of which is the best firm for your needs.

1. The base fee

Robo advisors typically charge a fee based on a percentage of the assets you place under their management. A base fee of 0.25% seems common among industry leaders. Since the premise of Robo advisors is to lower investment expense through automation, checking the base fee is a good place to start. Note that, in addition to this fee, you will also have to pay the expense ratios of the funds that are used to build your portfolio.

2. Trading fees

Are there fees for each trade within the program? This could quickly become quite expensive, so look for Robo advisors that do not charge such fees. Also, if you plan to make some self-directed trades through the same firm, check that their commissions are competitive with those of leading discount brokers.

3. Fee reductions for higher balances

In theory, management should get more cost-effective with bigger account sizes. Typical Robo advisor accounts are less than $100,000; but if you have more than that to invest, you should see if you can get a reduced fee.

4. Captive vs. outside products

Some Robo advisors are affiliated with fund families and use their own products to build investment portfolios. You may get a broader range of choices from a Robo advisor that uses independent investment products.

Also check to see if the Robo advisor's asset-allocation model can account for assets you have outside their account such as an employer's 401(k) retirement plan.

5. Tax treatment

If you are planning to place a taxable portfolio under a Robo advisor's management, understand what tax-efficiency strategies they use and whether you are able to employ techniques such as tax-loss harvesting when needed.

6. Minimum account size

Make sure you have enough to qualify for a firm's services and are not so close to the minimum that you might fall below it after a market downturn or a withdrawal.

7. User interface

Play around with the user interface. It should be simple to use and work effectively on the device of your choice.

8. Socially responsible investing capabilities

If your investment guidelines include prohibitions against certain types of investments for ethical reasons or particular sectors you want to positively target, make sure the Robo advisor's system can accommodate these priorities.

9. Retirement-goal targeting

Besides managing your money, some Robo advisors offer tools that can help you see what level of saving will be necessary to meet your retirement goals. Integrating these targets with your investment program can help make sure saving for retirement is properly coordinated with investing for retirement.

10. Rebalancing methodology

Automated investment allocations need to be reset periodically to make sure they stay in balance. Look into each Robo advisor's methodology for rebalancing. Overly frequent rebalancing can be inefficient, while doing so too infrequently can lead to portfolios getting out of alignment as asset values change at different paces.

Choosing the best Robo advisor is just a first step. Once your program is in place, monitor it to make sure the fees are staying competitive and the Robo advisor is delivering as expected.

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