The traditional investment management industry is in trouble. Robo investing and online investment advice is becoming more and more prevalent and taking market share away from the big firms. More importantly, where it used to be amateurs and armchair investors proving a broad level of advice to do-it-yourself investors, this is shifting to more professional firms that have figured out how to tap into technology to provide professional level money management, for the masses.
Robo advisors provide robo investing services through technology, and make investment decisions on your behalf without the need for a lot of human intervention and hand holding.
Via the web, robo investing services walk a client through a series of questions designed to fully understand the investment needs, risk profile they would be comfortable with, and time horizon for the investment plan. Specifically, the questionnaire gets the required information to make informed investment decisions on behalf of the investor.
With that information, the robo advisor then gets to work and determines the right portfolio selection based on the questionnaire answers. This can vary from a very conservative portfolio with limited to no equity exposure, to a more aggressive portfolio with a higher percentage in equities or other asset classes like real estate and natural resources.
No matter what the asset classes are, these portfolios use exchange traded funds (ETFs) to build the portfolios. ETFs are investments that provide broad diversification to a market at very low fees (more on that later).
Upon signing up with a robo advisor, an investor using robo investing is left with a well-researched and financially sound portfolio that is managed for automatically.
Robo advisors have now captured over $15.7 billion the overall investment market. This is an increase of over 21% over a very short period of time.
What investors can take from this is that robo investing is not just a fad, or something that only millennials are interested in. The original belief that robo investors will only appeal to millennials because they want to shun the old stodgy investment industry is no longer valid. Instead, robo investing is a very viable alternative for all investors to obtain professional level investment advice, no matter how much money they have or what generation they belong to.
There are more and more robo advisors coming online globally every month. In addition to the robo advisor only firms like Wealthfront and Betterment, traditional investment management firms like Charles Schwab also are offering robo investing services and are seeing huge traction with their clients switching over.
Here are the largest robo advisors as of February 2017, as measured by assets under management (in millions of U.S. dollars):
A huge problem with the traditional investment management industry is it left many smaller investors to fend for themselves. They could not get access to the professional level money management that has been available to higher net worth investors.
The reason for this is simple: the minimums required to open accounts with traditional advisors started too high.
Due to the higher costs of offering traditional investment management, financial planners typically could not take in clients with less that $50,000 in investable assets. The reason for this is that the fees they generate on anything less that $50,000 does not cover their costs of doing business. Even as a client’s assets grow and fees scale down, the costs of using a traditional investment manager remains high, making their services inhibitive for smaller investors.
Alternatively, some robo advisors have no minimums required to open an account, and some only require as low as $500 to open an account. In addition, because of the much lower infrastructure requirements of running a robo investing business, the fees are much lower. We’ll cover more on robo investing fees next.
According to management consulting firm Deloitte, robo investing customers charge annual fees that normally range between 0.02% and 1.0 % of the assets under management. On the other hand, traditional investment management companies charge on average between 2.0% to 3.0%. Even with a sliding scale, traditional firms are unable to compete from a fee perspective.
Here is an example of how a sliding fee structure of a traditional investment management firm works. It is clear to see that even with investable assets over $1 million, fees remain high:
The following chart, again from Deloitte, highlights exactly why robo advisors are cheaper. To cover costs, traditional firms need 100% more assets under management to break even. The costs they need to cover include more people and more physical infrastructure (i.e. buildings).
The real kicker is that robo advisors can provide the same level of service, and in some cases better service, for lower fees. Here is a comparison of those services and how they differ (hint: it’s all about the use of technology to reduced costs and deliver the same value!):
Robo Investing Takes the Emotion out of Investment Management
Money can bring out the worst in people. In particular, investment decisions based on emotion are usually not ideal. We buy when we should be selling, and sell when we should just hold on.
Robo investing helps to manage these emotions by putting a portfolio on auto-pilot. Once the initial work is done with the questionnaire that determines risk tolerance and investment goals and the portfolio is set up, all the investor needs to do is sit back and let the robo advisor do all the work.
There are no additional decisions to make or investment management actions to take.
All it takes is the understanding that markets move up and down and your portfolio will do the same. Robo investing still provides clients with access to their money at any time, however by removing the opportunity to make poor portfolio decisions that will ultimately lower performance.
As discussed, robo investing utilizes ETFs to create portfolios that are aligned to an investor’s risk tolerance, investment horizon, and goals. More specifically, there are a few reasons why robo investing uses ETFs that are important to understand as they are key to why the robo advisor model worlds.
Diversification: When an investor buys an ETF, they are ultimately buying hundreds or thousands of stocks or other investments like bonds. This diversifies the investor away from the risk of holding just one or two investments in a portfolio.
ETFs are Passive: Passive investing does not try to beat the market like active investors do. Instead it simply tries to get the exact same returns that the stock market gives. For example, if the FTSE 100 is up 8% in a year, then an ETF that tracks the FTSE will be up 8% (or very close to that) as well. Alternatively, if the FTSE is down 3%, then the ETF will be down around 3% as well. By investing passively investors get the market returns, without the added cost of trying to beat the market.
Highly Visible: ETFs are extremely transparent; you will know exactly what assets the ETF holds on any given day and whether it is doing its job. For example, if an ETF that tracks the S&P 500 is only up 3% while the S&P 500 is up over 8%, then that ETF is “broken” and another ETF should be purchased. On the other hand, mutual funds are only required to report periodically so you may not know it is not performing well until it is too late.
Easy to Buy and Sell: ETFs trade just like stocks, and are easy to buy. This makes it easy for robo investing services to cost-effectively get access to the best investment products available.
Low Fees: This is the most important reason that robo investing services use ETFs – they offer very low fees. Compared to mutual fund fees which can be much higher that 1.0%, ETFs often have expense ratios as low as 0.05%.
These characteristics allows the robo investing approach to work, and is a key reason why robo advisors have gained traction over the past few years.
When an investor signs up for a robo investing service, they will get access to a portfolio that is designed based on their needs. Taking into account risk tolerance, investment goals, and investment horizon, the robo advisor will determine what asset allocation will provide the best balance between risk and reward for that investor.
When building portfolios, robo advisors have many investment options available to them. Here is a summary of the main ones that investors will typically see offered in robo investing portfolios (from a U.S. perspective):
With these options, robo investors will build portfolios that meet the return and risk requirements for pretty much any investment scenario possible. For example, wealthfront publishes the minimum and maximum allocations for each of the above asset types and depending on the investor’s needs, portfolios are built with these minimums and maximums in mind.
Taking this a step further, we can look at example portfolios. Here is an example of a portfolio for an investor who is looking for a bit more risk than average (again from wealthfront):
It is clear to see that the majority of this portfolio is invested in riskier equites, which will more than likely lead to higher returns over the long term. A portfolio that is built for an investor with much lower risk tolerance will have a bond allocation that is a lot higher than this.
This type of portfolio allocation and the methodologies used to determine them have historically only been available to investors willing to pay more for this type service. However, with robo investing, investors will less capital are now able to get access to these portfolio and ongoing management.
When considering using robo investing in your own portfolio, here are several key considerations to keep in mind. These will help to make sure the robo advisor meets your specific needs:
- You need to be comfortable with a robo advisor making investment decisions for you.
- Always check to make sure the robo advisor is registered and is in good financial shape before committing your money to them.
- Read and fully understand the terms and conditions of investing money with the robo advisor firm. Know how you can get access to your money and what fees you will be charged for the various types of transactions.
- Determine who is holding your money – who the custodian is. Make sure the custodian is a well known and viable bank.
- Always answer the questionnaire honestly and accurately. If you answer in a manner that misrepresents your true risk tolerance or investment horizon, then the portfolio you get may not be what you need.
If you follow these recommendations then you stand a good chance of getting the right robo investing service for you.