Why Do So Many Robo Advisors Use ETFs?

If you’ve taken a passing glance at just about any robo advisor on the market, you’ve probably noticed that the portfolios they offer are probably made up of something called ETFs. An ETF has many advantages to individual stocks, and is a central aspects of Modern Portfolio Theory, which itself is at the core of many a robo advisor’s business model.

ETFs are pretty easy to understand, but there are some common misperceptions about what they are. Rather than debunking bad information piece by piece, we’ll start from scratch and explain what an ETF is, why it is such an important investment innovation, and explain why robo advisors have been so successful using them.

What is an ETF?

First things first, “ETF” stands for “Exchange Traded Fund”. It has much in common with a mutual fund (hence the “fund” part), in that it’s composed of little pieces of hundreds or even thousands of different company stocks. The way an ETF differs from a mutual fund, however, is that you can buy an ETF one share at a time, just like a stock. In short, it’s a fund that trades like a stock. Pretty cool.

Exchange Traded Funds

Why Are Exchange Traded Funds So Important?

But this isn’t the ETFs only important innovation. Jack Bogle of Vanguard is closely associated with the ETF, not because he invented the idea but that he popularized it. Bogle chose the ETF to be the core of Vanguard’s business primarily because they have such good results (often) and because they’re so cheap to own (usually).

Exchange traded funds are closely associated with Index Funds. Index funds are a collection of stocks, bonds, or other assets taken from a list like the S&P 500 index. An ETF that follows the S&P 500 would include all the companies within the S&P 500, no more no less. Therefore, it would track the performance of the S&P 500.

This is a great thing because for many years, we didn’t have these funds, and professional investors and investment managers had to piece together their portfolios from scratch, one stock at a time. Sometimes this worked out, but because these portfolios were usually much, much less diversified than a single ETF is today, one or two points of failure could bring down the whole portfolio. Think of an index-linked ETF as a bed of nails - the more nails, the less likely you are to get hurt when you put your weight on it.

As investment managers picked out stocks for their clients, they charged a great deal of money for their effort, often 2% annually or more. For an investor who is hoping to maybe make 10% in a good year, this 2% hit is huge. ETFs, however, are based on lists of companies. Nobody “chooses” the companies, really. The fund just follows the index.

As such, ETFs are way cheaper to own than portfolios managed by human beings. What’s more, index funds tend to have better returns than the portfolios of professional account managers who are just trying to pick winners. Expensive and failure-prone, professional investment managers (with some notable exceptions) have simply been outmoded by ETFs and their related products.

Why Do Robo Advisors Use Exchange Traded Funds (ETFs)?

By now you can probably already guess why a robo advisor would use ETF securities in their customer portfolios. The main reasons are:

1) ETFs are inexpensive. This makes the robo advisor attractively affordable to new clients. Every fund in the world has an “expense ratio” - the amount of fees that the ETFs owner has to pay each year for the privilege of holding the fund (this money goes to the team that controls and sells the fund). ETFs are also cheap to trade. Rather than paying fee after fee to trade stocks one at a time, an ETF gets you all the stocks you’d want and more, with a single affordable transaction fee. The robo advisor can pass these savings down to you, the client.

2) ETFs are easy. The robo advisor doesn’t have to pay someone to come up with a collection of stocks that’s going to (hopefully) have good returns. ETFs and index funds are going to do better most years anyway. Why add this extra expense for something unlikely to pay off?

3) ETFs are super diversified. This isn’t the case with every ETF (sometimes an ETF will be built around an industry or asset class, making them less diversified), but the popular ETFs like VTI are composed of many hundreds of companies. As such, they are much more stable than conventional hand-picked portfolios, while still being linked to the success of entire economies or industries. For some, the typical robo advisor portfolio may even be too diversified, with success in one sector and failure in another cancelling each other out. However, for the most part, this diverse and conservative approach to investment is perfect for investors, especially new investors who are looking for an easy and effective way to start saving in earnest for the future.

Now you know what an exchange traded fund is and why they’re so useful and popular. You’ll also understand the business model of the average robo advisor and its associated costs much better.

Remember when we said human investment managers often charge about 2% of an account balance each year for all the hard work they do. And yet, many of them fail to “beat” their country’s stock market growth rate. 2% is too much to pay for substandard results. This is where robo advisors really show their value.

At an average 0.25%-0.45% annually, robo advisors are anywhere from ¼ to ⅛ the cost of the average human investor. Add to this money saving services like tax-loss harvesting, and your robo advisor might be effectively free! All of this is made possible by the dirt cheap and super effective ETFs upon which your robo advisor portfolio is based. Here’s to low fees and big returns, all with the effortlessness of a robo advisor managed account.