ROBO-ADVISORS – What Investors Need to Know
Perhaps you have heard the term “Robo-advisor”, or even use one for your investments. Robo-advisor is a broad term that describes a number of technology platforms that provide automated investment services. Such services range from trade execution only, to those that employ algorithms to determine a client’s asset allocation and risk tolerance. The typical Robo-advisor uses a generic questionnaire to collect information from its clients. It then applies that information to determine the client’s risk tolerance and in turn, an appropriate mix of investments, generally low cost exchange traded funds (ETFs) or other passive investments. This model completely eliminates human labor from the financial planning and investment process – hence the term “Robo”. It should be noted that several Robo firms have expanded this model and offer clients access to a human financial professional, for an additional fee. Such access, however, is usually limited to electronic communication.
The use of technology and algorithmic asset allocation by the Robos has made asset allocation and investing accessible to many individuals who were previously unable to work with a traditional advisor. The main disruption Robo-advisors brought to the industry is pricing. Robo-advisors are a lower-cost alternatives to traditional (human) advisors. By eliminating humans, Robo-advisors typically charge a flat 0.2%-0.5% assets management fee, which is lower than fees a human advisor would charge for a small account, about .8%-1%. In addition, before Robo-advisors, automated portfolio allocation software was only accessible through a professional financial advisor. An individual would have to provide his/her information: financial situation, goals, expectations, etc., to a financial advisor who, in turn, would input this information into their firm’s proprietary software to determine an automated asset allocation. At this point, the financial advisor would then use what he or she knew about the client’s emotional biases to tweak the asset allocation and overall financial plan to make it suitable to the individual client. With the advent of the Robo-advisor, this technology became directly available to the public. Many investors of modest means or without complicated situations are happy to forgo professional human advice. Lastly, most traditional advisors have account minimums, which render them inaccessible to certain investor groups, such as small business owners who have most of their net worth tied up in illiquid assets, or millennials who are just starting to accumulate assets. Robo-advisors usually have low ($500) to no minimums to begin investing, which has allowed them to be indiscriminately accessed by all that would like to invest. To its credit, the success of the Robo-advisor industry has indicated that there is a demand across all demographics for financial advice, including those previously under-served by the big banks and Wall Street.
As with any technology, there are pros and cons to Robo-advisors. In an environment where interest rates are near all-time lows and equity returns are expected, by many in the community, to be low as compared to historical averages, it is important to minimize fees, which can have a material effect on performance. One can argue, however, that Robos, for what they offer, are actually expensive. This is because a portfolio of ETFs can be easily replicated for less than what the Robos charge.
The lower fees come with a cost. The Robo investor does not benefit from the human experience and expertise. Often it is the traditional advisor that provides an investor the emotional support and fortitude to stick with the investment and financial plan. A computer cannot take into account the human element that accompanies a financial plan. Human financial advisors provide much more than an automatic asset allocation. They often offer family planning and governance, asset protection, wealth transfer, risk management, tax strategies, business succession and exit planning, etc. With lower fees comes a lower level of service. As the saying goes, you “get what you pay for.”
The Robo-advisor model does not allow for any customization or special circumstances. All investors are segmented into risk buckets and invested accordingly in a pre-determined model. Considerations such as unrealized capital gains in legacy positions, emotional attachments to certain stocks, or specific investment needs are not taken into account. Rather, the entire portfolio is pushed into the Robo-model. It may also be problematic if the model assumes that the investor is aware of his/her risk tolerance. For traditional advisors, it may take several meetings and conversations with a client in order to ascertain the client’s true tolerance for risk and volatility. Many younger investors using a Robo-advisor have not yet experienced a so-called Black Swan event or significant market loss. Consequently, without human advice many investors may not be able to stay the course that would help them achieve their financial goals.
While electronic platforms have made the capital markets more accessible for certain people, the complexity of many investors’ situations require much more attention than a computer alone can provide.
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