Robo-Advisors Are A New Fin-Tech Innovation; Are They Worth It?

the robots are coming

Robo-advisors are a recent innovation in the fintech industry. The two best known companies are Wealthfront and Betterment, although Schwab is aggressively moving into this business.

What is a robo-advisor?

It’s an automated investment advisor. Instead of talking to a human financial advisor and discussing your age, income, expenses, goals, savings, and risk tolerance, you answer a questionnaire. The robo-advisor uses an algorithm to determine the best asset allocation and investment strategy for you. Typically, the robo-advisor invests in a mix of low-cost ETFs, rather than individual stocks and bonds.

Your portfolio is monitored over time and the robo-advisor automates any re-balancing of your different investment assets. For taxable accounts, it also pays attention to minimizing your taxes through strategies such as tax loss harvesting.

How much does a robo-advisor cost?

Betterment and Wealthfront charge a fee of 0.25% of the assets under management. In addition, the ETFs in which they invest carry their own expenses but these are typically low — let’s say the ETFs average 0.10%. So, the all-in cost of using one of these services is ~0.35%.

Schwab does not charge a fee. Instead, their robo-advisor invests in Schwab’s own ETFs and these ETFs typically have higher fees than other ones — closer to 0.25% instead of 0.10%. They also pay less than a market rate on any cash that is held in your portfolio and they essentially pocket that difference. In the end, Schwab’s total fees are comparable to Betterment and Wealthfront but hidden better.

These fees are significantly less than a human financial advisor who typically charges a fee of ~1%, along with additional fees that may add another 0.5% for the more expensive mutual funds or individual stocks in which they invest. For the human, let’s call it an all-in cost of 1.5%.

The robots are a good deal compared to a human but if you’re a do-it-yourself investor, you’re paying 0.25% more than you would incur if you bought low-cost ETFs and/or mutual funds on your own.

How does it compare to a target date fund for retirement investing?

Clients of mine know that I’m an advocate of low-cost target date funds for retirement savings. They perform the same asset allocation re-balancing but are less expensive than a robo-advisor. As a comparison, the Vanguard Target Retirement funds charge an expense fee of 0.15%. I would expect the performance of a robo-advisor to be similar to Vanguard’s target date fund for retirement savings, adjusted for the differing fees.

Should you use a robo-advisor?

These robo-advisors are certainly new, shiny, and high tech but I don’t see their value for retirement savings. I think you’re better off in a low-cost target date fund where you can invest your IRA and “set it and forget it.”

For non-retirement savings, the answer is not as clear as circumstances and investing goals can vary widely. A single low-cost index fund may not be able to capture your goals as well as a robo-advisor might. And, the robot’s tax optimization strategies are likely better than what you would do on your own. In that case, it may be worth paying a bit extra.

On the other hand, if your savings goals are short-term oriented — e.g., an upcoming down payment, car, wedding, etc. — then it is not clear to me that you’re better off paying fees of 0.25% when a mix of a low cost stock index fund and a high yield bank savings account might be better and cheaper. Similarly, if you’re saving for the long-term and want to invest 100% in a diversified stock fund, the robo-advisor offers no real advantage either.

Overall, the robots are a useful and low cost innovation compared to the human advisors, but they’re a bit more costly than a do-it-yourself alternative.

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