Robo-Advisors: What are they and why should you care?

RoboAdvisor4Dear Mr. Market:

The financial services industry is notorious for creating new terms and services in an effort to meet the ever-changing needs of investors. Often these ‘solutions’ are quickly adopted and become broadly used while others simply fizzle away only to be quickly forgotten. Unless you’re inside the industry you won’t hear the term “Robo-Advisor” but with advertising and slick marketing you will soon be solicited by one.

As with any new service or product there are many different models that companies are using as they rush to be part of a new fad. The basic definition of a Robo-Advisor is:  a class of financial adviser that provides portfolio management online with minimal human intervention. You might not be aware of these offerings but with several large firms introducing new strategies this year it is a safe bet that you will hear about Robo-Advisor’s in the coming months.

The vast majority of these firms have only been in existence the last five years but the growth they have experienced is dynamic and catching the attention of many large national firms. Currently there are over 15 established Robo-Advisor firms – the average account size is just over $20,000, each firm has over 20,000 clients and $200 million in assets. According to the research group Corporate Insight, they posted over 36% in asset growth in just four months last year (April to July). The growth of these firms has been impressive but should it really be that surprising?

Robo-Advisors target market is a segment of the market that has long been underserved and some would say flat-out ignored. The typical investment advisory firm has targeted investors with portfolios worth $500k and above. Investors with amounts under that were forced to become ‘Do It Yourselfers’ and not get any professional help or guidance. Robo-Advisors focus on these clients and are now finding that their target market is much larger than ever expected. According to Bill Harris, CEO of Personal Capital, there are over $32 trillion in investable assets in the United States; 33% to 40% are in this under serviced segment with demographics that will only continue to grow.

RoboAdvisor1How do Robo-Advisors work?

Ultimately what separates a Robo-Advisor from the traditional advisor model is the use of technology over human interaction. They embrace automation in an effort to streamline their offering and make it scalable to the masses. The process is initiated by the prospective client going online to the Robo-Advisor’s website. They will be prompted to fill out a survey or questionnaire to help establish their risk tolerance and target allocation. Once this has been processed and the account has been funded the firms automated investment process quickly takes over. Each firm has a different twist with how the investments are managed but one thing that is consistent is that technology is the driving force and not an individual.

The investor will be able to access the account online and monitor how their investments are performing. There will be no quarterly meetings or financial plans that are periodically reviewed to ensure that they are on track to meet their goals and objectives. Millenials (20 – 30 year olds) have quickly adopted and migrated towards these offerings as the majority of them are attempting to save and invest with relatively simple financial situations. They are comfortable with doing business and every day transactions online: shopping, banking and even dating. As investors continue to evolve, Robo-Advisors will need to adapt as well, this could ultimately be the factor that will dictate their longevity.

Let’s take a look at one of the largest Robo-Advisors today, WealthFront with assets over $1.8 billion. If you visit their website it walks you through some very basic questions. We stated that we wanted a diversified portfolio for a 40 year-old individual. Four questions were then asked regarding: income after taxes ($85K), value of cash and liquid investments ($50k), growth vs. taxes (both equally) and how we would feel if the market went through a 10% correction (sell some). Based on the answers we provided we were given a risk tolerance of 6.5 out of 10. Below is their suggested allocation:

35% U.S. Stocks

18% Foreign Stocks

15% Emerging Markets

6% Dividend Stocks

5% Natural Resources

21% Bonds

From there the website asks if you want more information or if everything looks great and you are ready to open an account. It’s that easy! Or is it? Is your financial situation so easy that it can be solved with four standard questions? Let’s take a look at the positives and negatives associated with this new investment solution…

Positives:

  • Minimum investment – often as low as a few thousand dollars.
  • Lower management fees, starting at around .25% compared to traditional advisors at 1% or much more.
  • Good for individuals that have a very simple financial situation.
  • Emotions are removed from the process.
  • Discipline to remain in asset allocation.
  • Easily accessible.
  • Hey…it beats listening to Jim Cramer and buying five random stocks he won’t care about next week!

Negatives:

  • No interaction or ability for an investor to have portfolio input or customization.
  • As an individual’s financial picture changes they will be required to proactively make changes and not rely on an advisor.
  • Robo-Advisor will view personal finances as being static and never changing.
  • How will Robo-Advisors react in a market correction of 10% or more? Systematic computer high frequency trading issues dominated headlines only 10 months ago!
  • Potential for hacking and/or data and security breaches.
  • Some platforms could steer you towards products or even money markets where the firm (or related partner) make more money and create a possible conflict of interest.
  • There is “no such thing as a free lunch”. Expect to pay for something whether it be via lack of service or by being cross-sold other offers and services.

With firms like Charles Schwab, Fidelity and Vanguard announcing that they will be offering a Robo-Advisor service, consumers could be inundated with various offerings. With built-in sales teams that will undoubtedly be incentivized to push these new products investors need to take the time to educate themselves. Ultimately the decision to use a Robo-Advisor or hire a traditional Investment Advisor should hinge on the individual investors circumstances and preferences.

Robo-Advisors are certainly not a ‘one size fits all’ type of solution! One way to think about this is how you personally get your hair cut. Are you they type that goes to a stylist that you know and trust? Are you more the type that goes to Super Cuts, Great Clips, or Fantastic Sams? Or perhaps you just want to bang out your haircut with the use of a Flowbee and some clippers in the backyard?!

RoboAdvisor2For investors that struggle with deciding which is a better fit for their needs perhaps they should look at a blend or ‘hybrid solution’. Many firms have adopted technology and found that they can scale their business to meet the needs of investors that previously did not fit their business model. The financial services industry will continue to evolve and offer new solutions to address what investors demand. Take the time to find the solution that is best for you and your current situation but don’t rush into the next fad just because it’s being marketed to you.

One thought on “Robo-Advisors: What are they and why should you care?

  1. Pingback: Edward Jones: Behind the numbers and survey results | Dear Mr. Market:

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