Robo-advisors are set to replace financial advisors in the same way that online banking is replacing bank tellers. This rapidly growing service offers many of the functions of a financial advisor, but at a fraction of the cost. By one estimate, robo-advisors will have $2.2 trillion in assets under management by 2020.
A robo-advisor is an automated, online financial advisory service that helps manage client portfolios using computer algorithms. What is under the computerized hoods of these online services? Despite differences, their structure is similar. Starting with the collection of basic information on investors including their financial condition, age and risk tolerance, Robo-advisors use a variety of techniques – including pre-set model portfolios, mean-variance optimization and Monte Carlo simulation – to construct diversified portfolios that are typically populated by low-cost Exchange Traded Funds (ETFs).
It may surprise many investors to learn that the engine used by robo-advisors to construct client portfolios is similar to that used by financial advisors. Financial advisors collect the same information as robo-advisors and then use the same algorithms to construct “ideal” portfolios. Both use some variation of Modern Portfolio Theory (MPT) to construct a model portfolio based on the information provided by the investor. It is therefore no surprise that the portfolios recommended by financial advisors and robo-advisors are very similar. In fact, some robo-advisors, such as the well-known Financial Engines, started as tools that investment advisors used to develop client portfolios, and many investment advisors now use robo-advisors to help advise or manage their clients’ portfolios.
All the portfolios recommended by financial advisors or robo-advisors are variations of the 60/40 portfolio (60% in stocks and 40% in bonds). The major asset classes are then divided into sub-classes including small cap, international, corporate bonds, etc. The number of sub-classes in a portfolio can vary from a handful to over ten. Some robo-advisors throw “alternative investments” such as emerging markets, real estate and commodities into the mix.
The allocation between stocks and bonds changes as the investor becomes older in a process known as “lifecycle investing.” Older investors are more interested in assuring the safety of their investments and in generating cash flow than they are in growth. Their portfolios are therefore skewed towards bond investments. Similarly, investors who are risk averse will have portfolios that have a higher allocation to bonds. Younger and less risk averse investors are presented with portfolios with a higher allocation to equities.
How can investors evaluate the relative benefits of financial advisors and robo-advisors? Part of the answer is the extent to which an investor is comfortable with using Internet-based financial services, whether on computers or mobile devices. Millennials (born between 1980 and 2000), who are already use Internet applications to manage various aspects of their lives, are natural users of robo-advisors and are being heavily targeted by these services.
Another consideration is the extent to which an investor is knowledgeable about investments and portfolio management in general. While robo-advisors are designed to be easy to use, they still call for at least a basic knowledge of investments. Because a large portion of investors lack this knowledge, financial advisors will always have a role to play in providing education to less knowledgeable investors. It is also the reason why some robo-advisors, such as Vanguard and FutureAdvisors, offer investors the option of working with dedicated investment advisors, although for an additional fee. This also appeals to investors who miss the personal touch of a financial advisor.
Robo-advisors have a number of advantages over financial advisors. The first is that robo-advisors typically charge lower fees. In addition, robo-advisor fees and services are more transparent. Finally, switching from one robo-advisor to another is a great deal easier than switching financial advisors.
With over 200 robo-advisors competing in this space, how is an investor to choose? A number of questions will help in the selection process: What are the fees for a basic version of the robo-advisor? These can vary from free (for example, Schwab and WiseBanyan) to close to 1% of the assets in the program. It is also important to guage what is included in the basic service. For example, does it include portfolio rebalancing and/or tax harvesting or are these only available for additional charges? For those looking for more highly diversified portfolios, some robo-advisors offer a greater range of asset classes than others. Finally, robo-advisors differ in the underlying engine that drives the asset allocation, ranging from fixed templates to mean-variance optimization and Monte-Carlo simulations.
Do robo-advisors present an end to the role of financial advisors, as implied by some of the publicity that surrounds them? No. There is still an important role for financial advisors, especially in activities other than investments. However, robo-advisors are comparable to financial advisors in some respects, but at a substantially lower cost. With long-term interest rates under 2%, a savings of 0.25% or 0.50% is meaningful, and will assure that robo-advisors will capture a growing share of the investment advisor market.