Your Guide To Robo Advisors

Professional money management used to be only for high net worth individuals. If you had a big enough portfolio, than a investment manager would be available to help you structure your portfolio in order to manage risk while maximizing reward. In other words, they helped the rich get richer.

Why is this level of sophisticated professional money management not available to the rest of us? Why is it not available to people who are just starting to invest but want to grow their portfolio into millions of dollars?

That is where robo advisors come in.

Robo-advisors have combined technology and professional investment management services to offer what has traditionally only been available to the rich, and made it accessible to everyone. Investors who are just starting, or who have even built up a good-sized nest egg but need more support to maximize performance, can now get the best investment research working for them.

Robo-advisors work with investors to build, maintain, and administer portfolios automatically and at way lower fees than traditional investment management has ever been able to offer.

This guide will help you understand what robo advisors are and how they work. In addition, this site has details and reviews on the best robo advisors available.

What Are Robo Advisors?

Robo advisors are digital tools that investment clients can use to get a professionally managed portfolio, at a much lower cost. Where traditional investment management firms seek out higher net worth clients, robo advisors are accessible to anyone, even those with very small amounts of money to invest.

Some robo advisors only require a minimum investment of $1,000.

Robo advisors maintain low fees by using technology to automate the investment process, removing the expensive infrastructure required in more traditional investment service models. For example, robo advisors can be 100% online, only requiring a very small staff to manage the technology, marketing and business side of the company. This helps keeps costs low which gets passed on to the customers.

The original model was that robo advisors removed all human intervention and advice to keep costs low. However, even that is changing and many robo advisors are now offering the option of personalised advice. These firms are doing a good job of combining the efficiencies gained from the robo advisor model, but also allowing for personal one-on-one advice where a client’s needs are more complicated. Even with that added support, costs stay low which means more money left over for the investor.

Don’t just think of robo-advisors as some nameless faceless algorithm in the cloud anymore. Think about them as a way to combine the best of technology with the option for more personalized service when required.

How Do Robo Advisors Work?

The image below Robo-advisors work by automating the investment process to build and maintain a diversified portfolio. Through a web-based tool on a desktop / laptop, or an app on a phone or tablet, a client’s portfolio is built after a questionnaire is completed.

This questionnaire provides the robo-advisor with key insight into the investor’s goals, time horizon, and risk tolerance. With that information, the investor’s money is invested into a portfolio that has an asset allocation that fits their needs.

More importantly, the asset allocation and portfolio management principles are based on academic study that researchers from the top universities have determined to be the best approach to investing. The most common theory applied by robo-advisors is modern portfolio theory.

Here is how Investopedia defines modern portfolio theory:

Modern Portfolio Theory (MPT), a hypothesis put forth by Harry Markowitz in his paper "Portfolio Selection," (published in 1952 by the Journal of Finance) is an investment theory based on the idea that risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. It is one of the most important and influential economic theories dealing with finance and investment.

Essentially, modern portfolio theory attempts to provide the greatest opportunity for return with the lowest amount of risk. shows that higher returns come at a higher risk of loss (source: PragCap). Robo advisors use efficient portfolios to provide the highest possible returns while balancing the risk the investor is exposed to. This is an important concept for long-term investors to be aware of, and is easily applied by robo advisors.

Modern portfolio theory graph

Once the portfolio is build and the investor’s money allocated, then the portfolio is automatically rebalanced throughout the year to make sure it maintains the target asset allocation.

In addition to this automated portfolio construction and management process, some robo-advisors offer additional services to help maximize returns and minimize risk.

For example, tax loss harvesting can be automated to take advantage of market dips to rebalance a portfolio. The technology can automatically monitor the portfolio and make decisions that can maximize growth.

In summary, robo-advisors offer professional portfolio management in an automated and easy to use online environment.

What Are ETFs And Why Do Robo Advisors Use Them?

The next logical question is what types of investments does an investor’s money get invested in using robo-advisors?

Diversified portfolios are built and maintained using exchange-traded funds. Exchange-traded funds (ETF) are investment products that track a stock market index for very low fees compared to other products like mutual funds. In addition to low fees, they also provide massive diversification by investing in whole markets, rather than just one or two individual stocks or bonds.

ETFs can track a wide range of indexes, giving investors access to whole markets. For example, the most popular ETF is the SPDR® S&P® 500 ETF (SPY). The SPY is designed to track the performance of the S&P 500 stock market index. When an investor buys the SPY, they are essentially buying the whole S&P 500.

In the U.K., there are ETFs that track the performance of the FTSE 100.

There are also ETFs that track the bond markets, such as the iShares Core £ Corp Bond UCITS ETF (SLXX), which tracks the performance of an index composed of Sterling denominated investment grade corporate bonds. ETFs are available for pretty much every market available today.

ETFs are chosen over other investment products for three reasons:

  1. Low Fees: ETFs offer some of the lowest fees available to the investing public. 
  2. Wide Diversification: A single ETF can provide access to thousands of individual stocks or bonds. When an investor buys an ETF that tracks the FTSE 100, they are buying all stocks in that index using one simple investment. 
  3. Easy to Invest In: ETFs trade just like stocks and are bought and sold on the stock market, making them easily accessible and cheap to buy and sell. 

Do Robo Advisors Provide Active Or Passive Investing?

Robo-advisors use ETFs because they utilize a passive style of investing. Passive investments are designed to match the returns of the market. Costs are kept low because no additional resources are required to constantly research the market. Performance is good because they simply strive to get the market returns.

The alternative is active investing, which uses various strategies to attempt to beat the market. This often includes actively trying to time the market, or getting in and out of the market depending on market conditions.

Active managers seek out information to make investment decisions that they believe will make their investments perform better than the market. This style of management is more expensive as the managers need to be paid for their analysis. However, the problem is the extra cost of active management is not warranted as it does not work very well.

The SPIVA® U.S. Scorecard, which analyses the performance of the investment management industry in the United States, found that:

During the five-year period ending Dec. 31, 2016, 88.3% of large-cap managers, 89.95% of midcap managers, and 96.57% of small-cap managers underperformed their respective benchmarks.

Most investment professionals cannot beat the returns of the market. In fact, they have under-performed and provided their clients with lower returns than the overall markets.

This is exactly why robo-advisors have overwhelmingly decided to take an passive approach using ETFs. ETFs are able to actually meet the returns of the market, and at lower fees too.

Why Are Fees So Important?

The average investor’s biggest concern is investment performance. They are very concerned with how big of a return or gain are their investments providing them? Are they getting richer?

However, these investors should be concerned with a more important element – investment fees.

The chart below, prepared by the Securities and Exchange Commission in the U.S., highlights the impact fees have on a portfolio.

Robo Advisor Portfolio Growth Graph

Over a 20-year period, an investment of $10,000 that has to pay a 1.00% annual fee will have $30,000 less than a portfolio that is only charged a 0.25% annual fee. For many retirees, that is one whole year of extra income that is lost to fees.

In addition to just the annual fees, many traditional investment management firms have a lot of other fees that can quickly eat into profits. For example, many investment advisors charge commissions when an investment product is bought or sold. There may also be sales loads that provide incentives for advisors to sell you a specific fund or product. Finally, some investment management firms charge a percentage of profits, meaning that the more a fund makes, the more fees are paid.

Every fee that you pay leaves less money to invest and grow. That is why robo advisors work to keep costs low through technological efficiencies and using low cost ETFs in their investment choices.

What Fees Do Robo Advisors Charge?

Although robo-advisors are much cheaper than traditional investment management firms, they are not free. There are costs for them to look after a client’s money.

The fees charged by robo-advisors usually fall into two categories. First are the fees charged by the robo-advisor company themselves. This is typically a percentage of assets and/or a flat fee. For example, MunnyPot charges a £2.08p per month fee and a 0.11% platform administration fee on a £5,000 investment.

The second fee-type are the fees charged by the ETFs themselves. Robo-advisors do not collect these fees; they are taken directly by the ETF company. Depending on the ETF company, these ETF fees can range from 0.05% to 0.45%.

Robo-advisors are not free, but when compared to the average mutual fund fee of 2.35% (the average equity mutual fund expanse ratio in Canada), they definitely are a cheaper option than the traditional methods of professional investment management.

What Are the Key Benefits Of Using Robo Advisors?

The key benefits of using robo-advisors as part of an investment strategy are:

Low cost: Since robo-advisors build portfolios using ETFs and technological efficiencies, fees are much lower than portfolios built using active management.

Solid Portfolios: Using Modern Portfolio Theory as a guide, robo advisors provide access to well-researched and efficient portfolios that offer a good balance between risk and reward.

Remove Decision Making: Poor emotional decisions can have a negative impact on portfolio performance. Investors often buy and sell investments at exactly the wrong times. A robo-advisor takes away the decision making option and automates these decisions.

24/7 Access Via Digital Tools: Robo-advisors take advantage of available technology to provide investors with online platforms to provide full access to their portfolios and tools to help them be better investors.

Tax-Efficient: Many robo-advisors offer services that can minimize taxes to maximize gains. For example, some employ tax loss harvesting which takes advantage of temporary market losses to offset gains that would otherwise be taxed.

Low Minimum Investment: With only a small investment, robo advisors provide access to professional level management that used to be available to people with a high net worth. Some firms have no minimums to open an account.

Personalized Advice: As robo-advisors mature, they are expanding their product offering to provide even more personalized advice based on the client’s individual needs. Still leveraging technology and lower fees, they can now provide access to a human being who can help with the more complicated requirements of some investors.

Easy Sign-Up and Paperless: The most advanced robo-advisors do everything completely online, including signatures during sign up. This saves paper, is environmentally friendly, and very easy to do.

Overall, robo-advisors offer smaller investors with professional level investment management for a fraction of the cost that it would be when using more traditional routes.

What Are the Downsides Of Using Robo Advisors?

As with everything, robo-advisors are not perfect and do have some downsides:

Limited Personalization: Robo-advisors are built using more of a one-size fits all model. Although there are multiple portfolios available depending on risk tolerance and time horizon, most portfolios are similar and meant to meet most everyone’s needs. If an investor has more specific requirements, robo-advisors are may not be able to provide the personalization required.

Untested: Robo-advisors, and the technology they are built on, is still relatively new and untested. We do not know how they will perform during another market meltdown like in 2008.

Technology Can Fail: All technologies can have bugs or glitches that can impact how they behave. If the programming behind the robo-advisor is not written well, or able to handle the multiple types of scenarios that can be thrown at it, then that may impact performance over the long-term.

These are important downsides to consider, but as technology improves and the companies get better at providing their technology, many of these downsides should go away over time.

Does Using A Robo Advisor Mean No Personalised Advice?

Robo-advisor detractors usually use the presumed lack of personalized advice when trying to downplay how powerful robo-advisors can be. They talk about how the cookie-cutter approaches of most robo-advisors misses key opportunities for things like estate planning and wealth management. Their argument is that only human-based personalized advice can give clients the investment management they require.

However, what they fail to mention is that the majority of investors do not need personalised advice or complicated investment plans. Most investors only require the services already provided by robo-advisors; well designed portfolios based on a pre-determined risk and reward profile that systematically invests based on best practices and academically backed portfolio theory.

Only a very small percentage of the population actually requires complicated investment plans and investment products. Clients like the super-rich or families with multi-generational wealth tied up in multiple interests and multiple countries. For most of us, a robo-advisor service is all that is required to invest in a cost-effective and efficient manner.

That doesn’t mean that personalised advice is not available from some robo-advisors. In fact, more and more robo-advisors are starting to supplement their robo-advisor services with a human advisor who can help their clients through more complicated situations. These people are available via phone or online chat to discuss specific questions clients may have, and are able to provide advice on how to deal with those questions.

The primary service is through the automated investment platform, but when circumstances come up that require some more help, a human is only a call or chat away to get the answers needed.

What Does A Sample Robo Advisor Portfolio Look Like?

Robo advisors use well-researched investment practices to build well-diversified portfolios. They also make sure that all the main asset classes are included in each portfolio. This provides the investor to broad market exposure, helping to maximize gains and minimize risk through diversification.

Risk is then managed by altering the amount of exposure to equities. The more risk-adverse the investor is, the less money is placed into equities. If the investor is more comfortable with risk, and especially has a longer timeframe before retirement, then the equity component is ratcheted up.

Here is an example of how this works, from Canadian robo advisor WealthSimple. They offer three portfolios, adjusting risk from a conservative portfolio with lower equity exposure, a balanced portfolio with middle of the road equity exposure, and a growth portfolio with a more aggressive exposure. In the following images, look closely at how the equity and bond percentage change:

Wealthsimple Portfolio Allocation

WealthSimple Portfolio Allocation

WealthSimple Growth Portfolio

The right asset allocation is determined during account set up and with a detailed questionnaire that examines the investors goals, time horizon, and risk appetite. With that information, the investor’s money is automatically in a portfolio like one of the above. From there, the robo-advisor does all the work.

As the performance in each asset classes changes over time, money is rebalanced to ensure the target asset allocation percentages are maintained. This ensures that the target returns are achieved, with the chosen level of risk.

How Safe Are Robo Advisors?

Safety and security is a very important when entrusting money to an investment management firm. Robo-advisors have the added complexity of being new, somewhat unproven, and completely online which is very different than what many people are used to. With traditional investment management firms and banks, clients have become comfortable with being able to go into their local branch or call someone up on the phone.

Robo-advisors are the opposite of that: they have no physical presence, there is limited options for human contact, and they are completely technology based which some people just don’t trust yet.

However, robo-advisors understand this and have taken steps to ensure that their client’s money is safe and secure. For example, robo-advisors are registered as investment managers and are responsible for managing money to a fiduciary standard. This means that they must put the interests of their clients before their own. In addition, they must make sure that each investment they put a client into must be suitable for them.

In addition to the fiduciary and suitability standards, most robo-advisors protect client money and data in three ways.

1. Backed by a custodian bank: Robo-Advisors have arrangements with large financial institutions that act as custodians for all assets held on the client’s behalf. This means that the robo-advisor does not hold your assets, they only invest the money on your behalf. The assets are held by the highly regulated banks.

2. Data Encryption and Security: Robo-advisors have some of the best software and security engineers working on their teams. This means that data is encrypted and secured using state-of-the art security systems; bank-level security measures to ensure data is collected and processed securely. Most robo-advisors also use multiple data centres to ensure continuous system availability. If one data centre goes down, the other is available right away to take over.

3. Assets are Insured: Most robo-advisors also offer some level of insurance. For example, in the U.K. assets may be insured up to £50,000 by the Financial Services Compensation Scheme. In Canada, investments can be covered by the CIPF insured up to $1,000,000.

These three security measures ensure that a clients’ money is safe and the data transmitted back and forth is protected from unauthorised usage.

What are the Main Differences Among Robo Advisor Firms?

There are many robo advisors to choose from. This can make deciding on the right one difficult. To make this easier, Investoo has determined that most of the differences between services can be characterised using the following criteria:

Minimum Deposit Amount: Different companies offer different minimums to get started. Some require nothing to open an account, while others take a larger investment.

Asset / Portfolio Allocation: Depending on the robo-advisors approach to portfolio creation, the actual portfolios built can vary quite a bit depending on how the initial questionnaires are answered.

Annual Fees: — Given that the robo-advisor space is getting more and more competitive, annual fees are often similar. However, there can be key differences, such as the fees for larger amounts of invested capital.

100% Robotic Versus Some Human Assistance: In some cases, robo advisors are 100% automated with little to no human support available for unique circumstances. On the other hand, there are some robo advisors that offer their services as primarily robotic, with the option of getting advice from a human. Potential clients need to consider what their needs and comfort levels are with robo advisors, to determine which mix will work best for them.

Account Types Available: There may be differences in the account types the robo-advisor are set up to support. For example, options available in the U.K. may be a General account, a Stocks & Shares ISA, or a Self-Invested Personal Pension. In the U.S. account types may be individual, joint, IRA, and/or a 401(k) plan. Making sure the robo-advisor has the right account for the client’s needs is an important consideration.

Tax Harvesting and Other Services: Some robo-advisors offer tax harvesting services and some don’t. In addition, each robo-advisor can offer a variety of tools to help manage a portfolio, including fee calculator and retirement calculators. Some of these tools can be very helpful in determining how to manage a portfolio.

Who Should Use a Robo Advisor?

The final question is, who are robo-advisors best suited for? The answer can depend on the investor, but for most people it will come down to the following characteristics:

Investors with smaller accounts: Since robo-advisors provide professional level investment management that has traditionally only been available to high net-worth individuals, robo-advisors are great for those who are just starting to invest or have less than a few million dollars to invest.

Investors who are comfortable with technology and online services: Since robo-advisors use technology to solve investment problems, and are managed online, having a certain level of comfort and trust in technology is important.

Investors with little investment knowledge or experience: Robo advisors are perfect for people with little to no investment experience or knowledge. Robo advisors do all the work and invest based on modern portfolio best practices, so that clients do not need to worry about that themselves.

Investors with a longer time horizon: Robo advisors are not designed for short-term savers. They are best suited for activities like saving for college or retirement; goals that take many years to achieve. Markets move up and down, and the robo advisor portfolios take time to work so are best suited for investors with longer time horizons.

How To Get Started

This guide has provided you with a solid understanding of what robo advisors are all about. From how portfolios get created to how they are adjusted based on your risk profile, there is a lot of information in the above article.

So, if you are convinced that robo-advisors are for you – and there should be very few people they are not the right answer for – then what are the next steps?

On this site, there are profiles of many of the best robo-advisors available, including in-depth reviews for most of them. Read these profiles and the reviews, to see which ones tick the boxes that meet your requirements. Once you find the right one for you, sign up and get started. The longer you wait, the less time you have for your money to grow.