The Best Robo Advisor … For You

There's something very personal about choosing the right robot to manage your investments.

This is the seventh and final blog in a series by ETF.com's Director of Research Elisabeth Kashner on the new "robo advisory" industry. The first six, in order of appearance, are as follows: "Which Robo Advisor For My Teen?"; "Ghosts In The Robo Advisor Machine"; "Inside Robo Advisor Asset Allocation"; "Rebooting Robo Advisors' ETF Selection"; "Robots Leave Money On The Table"; and "Inside Robo Advisor Tax Loss Harvesting."

My son is ready to invest his bar mitzvah money.

He's choosing among robo advisors, and one ETF. I've helped him by analyzing the robo advisors' investment philosophies and asset allocations, the ways they select ETFs (here and here), and their tax-loss harvesting programs.

Last but not least, I'm going to help him frame the decision.

How To Choose

A portfolio's asset allocation is the biggest factor in determining long-term returns. It's the key choice.

I'll help my son choose among robo portfolios, starting with the equities. Equities will outweigh bonds in my son's portfolio, for a long time. Bonds come next.

There's no right investment philosophy. It's about finding the right fit.

Costs and services make good tiebreakers. These are personal, too, as their value depends on wealth level, tax status, personality and expectations about the future.

We'll go through all of these—equities, bonds, costs and services—one at a time. I'm going to focus on the robo advisors' 60/40 portfolios, because they'll give us a good look both at equity and fixed income.

Starting With Stocks

I'd like to show each firm's key equity tilt and risk level, so I compared each firm's equity portfolio to the Vanguard Total World Stock (VT | B-100) using ETF.com's tilts scoring (see p.11). The results below show how similar these portfolios are to the global equity markets.

For investors who like to hold the whole market, without many over- or underweights, Betterment is the best robo-advisor equity choice. For those who like a bit of variety, though, these tilt scores invite us to look deeper, to find out what drives the differences. If you want to look really deep, check out the appendixes at the end of my Robo Asset Allocation piece. For a shorthand version, read on.

Tilts

The robo advisors implement some popular strategies, including factor investing, which focuses on small-cap and value, as well as global growth strategies that often involve emerging markets. Let's look at factor exposure first.

The table below shows each firm's 60/40 equity portfolio's weighted average market cap and price-to-earnings multiple (P/E) in relation to Vanguard's VT, with a composite "small/value level" that combines the two equally.

Factor investors who seek small-cap and value exposure should prefer FutureAdvisor, while those who like growth investing should choose WiseBanyan, with its highest-in-class P/E ratio.

Some investors prefer to think geopolitically.

Many are drawn to the emerging market growth story, while others prefer to stick close to home. The table below shows the emerging market and U.S. weights for each of the 60/40 equity portfolios.

Covestor has the strongest emerging market exposure, while Invessence heads up the home-country fan club.

Wealthfront's 60/40 portfolio isn't tilted enough to stand out, but isn't plain vanilla either. It's tilted to large-caps but also emphasizes value. That's because it's the product of a real live investment committee. For folks who want a driver behind the wheel, Wealthfront is the clear choice.

Bond Basics

For any young person, equity will be the main driver of portfolio returns. But as he ages, my teen will need to think about bonds. That's why I'm analyzing the 60/40 portfolios, after all.

Global bond benchmarks are not necessarily the right foil for U.S. investors concerned with capital preservation.

Instead, we measure bond risk in absolute terms: duration, or interest-rate risk, and then credit risk. Credit risk measures the likelihood of getting the cash flows you expect—interest payments and the return of your coupon. Interest-rate risk measures the future value of those cash flows. Also, the tax situation gets complicated, forcing apples-to-oranges comparisons between municipal bonds and taxable bonds.

The table below summarizes duration and credit risk, and also shows which portfolios contain muni bonds.

Not everyone needs muni bonds, so I'll discuss each group separately.

Among the firms offering muni bonds, Wealthfront has the least risky bond portfolio, sporting the lowest duration and the highest credit quality. It's also the only one of the three to use munis exclusively; Betterment adds a sliver of U.S. corporates and a slug of international bonds, while Invessence includes junk bonds. Invessence is the most diversified of the bunch in terms of fixed income, with allocations to emerging market bonds, corporates and preferreds rounding out the portfolio.

Of the firms with taxable-only portfolios, FutureAdvisor takes the least risk, while WiseBanyan takes the most. FutureAdvisor is the most diverse of the three, adding TIPS and global bonds to the U.S. Aggregate.

Exposure Summary

Here's the top-level portfolio comparison:

Costs & Efficiencies: Sometimes The Deciding Factor

If my son likes more than one of these approaches, he might look at costs and services as a tiebreaker.

Robo-advisor costs involve more than just the headline fees. Taxes, trading fees and tracking error also play a role. Some offer services such as asset location, tax-loss harvesting, rebalancing, cash flow management and automated savings plans. A quick cost/benefit review will help us evaluate each package.

Hidden Costs

All the robo advisors post their management fees. That's the easy part.

Most cover brokerage fees, but FutureAdvisor and Covestor don't. We'll account for that.

There's more, though. Taxes and tracking error can add up fast. Taxes are personal, but tracking error isn't. Tracking error comes in two flavors: drag between a fund and the index it tracks; and portfolio gaps and overlaps. The drag is easier to measure, so we'll focus on that first.

ETF.com calculates the median 12-month returns difference between a fund and the index it tracks. You'll see the portfolio weighted average tracking differences in the table below. Invessence's choices of Market Vectors Long Municipal (MLN │ C-94) and the SPDR Barclays High Yield Bond ETF (JNK │ B-77) pushed up costs.

Gaps and overlaps can hurt too. If Invessence had used the U.S.-focused Vanguard Total Stock Market ETF (VTI | A-100) instead of the SPDR S&P 500 ETF (SPY │ A-98) and the iShares Russell 2000 ETF (IWM │ A-78), its 60/40 clients would have pocketed an extra 0.69 percent per year from the beginning of 2012 (Invessence's launch year) through Sept. 15, 2014.

Money-Saving Benefits

Robo advisors can help investors lower their tax bills. Asset location helps investors maximize the benefits of tax-sheltered accounts. Municipal bonds avoid taxes entirely. Some robo advisors also offer tax-loss harvesting. Let's value these services one at a time, starting with asset location.

For investors in the 25 percent tax bracket, ordinary income costs 10 percent more than qualified dividends or long-term capital gains, which are taxed at 15 percent. If yields revert to their five-year average of 5 percent, this slippage will cost 0.50 percent per year.

Wealthfront, Betterment and FutureAdvisor crunch the variables to optimize precious tax-sheltered account space. There are plenty of variables, too.

The higher that yields climb, or the higher your tax rate, the greater the asset-location advantage. Long-term asset growth rates matter too, because of capital gains on the nonsheltered assets. The amount of capacity in tax-sheltered accounts plays a part, as does your expected trading frequency, your life expectancy and your expected cash needs.

Munis For Tax Avoidance

Since 1990, broad-based munis have yielded an average 54 basis points per year more after tax than the Barclays U.S. Aggregate Bond Index, for investors in the 25 percent federal tax bracket. Add in a few more basis points for state tax and the ability to shelter qualified dividend income, and we can estimate the muni advantage at 60 basis points per year. Munis often carry more interest-rate risk and sometimes more credit risk than investment-grade taxable bonds—the tax advantage isn't risk-free.

Here's how muni use provides savings in the robo portfolios. The muni advantage is scaled by the weight of munis in the 60/40 portfolios:

Wealthfront's taxable bond portfolios hold muni bonds, and nothing else. Betterment and Invessence's greater diversification means less tax savings.

Hard-To-Value Benefits

As I explained in my previous blog, Inside Robo Advisor Tax Loss Harvesting, it's virtually impossible to estimate the benefit of tax-loss harvesting. Rebalancing requires a similarly complex set of estimates. In the end, the value of these services is investor-specific.

Other benefits are even more personal, because they're about how much attention you can pay to your investments. Some robo advisor firms will manage your cash for you, day by day, putting dividends and contributions to work immediately. Many will also allow you to set up an automated direct deposit, helping you to pay yourself first.

Wealthfront, Betterment and Invessence will help you adjust your asset allocation over time. Wealthfront will nudge you to reassess your goals periodically, while Betterment and Invessence will automatically reduce portfolio risk as time goes by.

For busy folks, these services can be truly valuable.

Here's the list of firms and the services they offer:

Robo-Cost/Benefit Example

Here's a mother's fantasy: Fast-forward 10 years. Pretend my son has $250,000 to invest, faces a 25 percent federal tax bracket, and has $100,000 of capacity in his individual retirement account (IRA). We'll say bonds yield 5 percent over his lifetime. I scaled costs to a 60/40 portfolio, and imputed a 0.20 percent asset location advantage.

Because FutureAdvisor and Covestor accounts have trading fees, I included an estimate of 0.05 percent per year in commissions. It's a rough guess.

The asset location advantage is scaled to the IRA capacity.

Here's how all the robo-costs add up, in this very specific case:

The overall robo-advisor costs are low enough to support any choice my son makes on robo-advisor asset allocation, though he'd have to be really keen on Invessence's or FutureAdvisor's philosophies to choose them over freebie WiseBanyan or tax-efficient Wealthfront and Betterment.

Putting It All Together

At ETF.com, we recommend investors first pinpoint the economic exposure they want, focusing on funds that select and weight securities to best meet their goals. Next, we suggest investors consider the costs of all appropriate funds. But we never suggest investors choose unsuitable funds on the basis of cost.

You should choose a robo advisor the same way.

Here's a table summarizing everything we've learned so far about the robo 60/40 portfolios.

HNW = High Net Worth

If you don't have strong opinions on investment approaches, you'd do best to avoid the more extreme approaches. At the 60/40 risk level, FutureAdvisor makes the heaviest factor bets in the equity market, Covestor tilts hardest to emerging markets and Invessence takes the highest bond risk.

Of the three with more moderate approaches, WiseBanyan works quite well for folks who don't need protection from the taxman.

For folks who need tax management, Wealthfront and Betterment offer a raft of services. Each has its own approach to portfolio construction, tax-loss harvesting, asset location, rebalancing and periodic portfolio updates. I've touched on some of these features in this blog series. No doubt I'll dive back in someday.

In the meantime, I recommend you think hard about the investment exposures you want, the features you value and the costs involved, and choose the firm that fits you.

The Man-Child Chooses

So, what fits my teen, besides his bar mitzvah suit?

At 13, he has no clue about investment philosophies, and he doesn't want to hear about them from his mother. For now, his best bet is to take few bets, and stick with a market-mimicking portfolio. For him, the choice comes down to Betterment, the most marketlike robo advisor; or VT, which replicates the global equity markets.

My teen is too young to take advantage of asset allocation, muni offerings and tax-loss harvesting services, because he has no retirement account, and pays no taxes. Lucky duck.

He's lucky in another way too. He has no real liabilities on the horizon. He doesn't need the ballast of bonds in his portfolio, not yet.

When my son has a job, pays taxes and feels ready to think about investment philosophy, I'll recommend he consider investing with a robo advisor. I'll help him walk through the selection process, identifying his asset allocation preferences, understanding his cost situation and assessing his need for services, so he can choose the one that works best … for him.

Robo advisors offer discipline, reasonable asset allocations and other services that will come in handy once my teen turns into a busy professional. I hope they'll add better tools, like state-specific muni bonds, refined ETF selection and a range of personalized value estimates for tax-loss harvesting, asset location and rebalancing. They have a decade, at least where my son's concerned.

For now, my boy has chosen to invest in VT. Mazel tov on your bar mitzvah, son.

At the time this article was written, the author held no positions in the securities mentioned. Contact Elisabeth Kashner, CFA, at [email protected].