Online financial advisories show promise, but have yet to face the test of time.
The so-called robo-advisory business is quickly growing, and it’s easy to understand the appeal of automated portfolio construction and management for a very low cost. This type of log-in, answer-a-survey, get-your-portfolio-underway type of experience has attracted millions of dollars from investors of all sizes. But there are risks that need to be understood.
Firms like Wealthfront and Betterment are some of the biggest names in a space that’s populated by at least a dozen firms. The segment came into the spotlight this week after reports surfaced that Vanguard—the largest mutual fund provider in the world and the third-largest ETF provider in the U.S.—is joining the robo-advisory industry.
A Vanguard representative told ETF.com the firm is still working out the details of its program, which is called “Personal Advisor Services,” and therefore cannot comment further other than to say it sees this program as an “evolution in our planning and advice services, resulting from what we’ve learned during our near three decades in the advice business.”
Vanguard Vs. Wealthfront Vs. Betterment
But the New York Times reported that Vanguard’s service will cost 0.30 percent a year in fees—$30 for each $10,000 invested. It will also require an initial investment of $100,000—a threshold the Times reported might eventually drop down to $50,000.
By comparison, Wealthfront charges 0.25 percent a year in flat fees—or roughly $20 a month for an account of $100,000 invested—but doesn’t charge a dime for investments under $10,000.
Betterment, meanwhile, has a tiered fee schedule that’s based on total assets. It ranges from 0.35 percent a year for balances of $100 to 0.15 percent a year for accounts of $100,000 or more. That’s $150 a year per $100,000 invested.
Both firms also allow investors to “roll over” 401(k) accounts to their platforms, meaning the “qualified” nontaxable status of assets in 401(k)s will be preserved in individual retirement accounts (IRAs).
Doubts Along With Excitement
But the jury is still out on whether robo-advisors represent the future of investment advice, or if they can even survive in their current iteration.
Passive-investing advocates such as Allan Roth, of Wealth Logic, see robo-advisors as an important step forward for investors of all sizes. Among the benefits these providers bring to the table, Roth points to cost advantages, tax efficiency and automated platforms that should help protect investors from, well, themselves.
“My industry—the financial planners and advisors—see robo-advisors as a huge threat,” Roth told ETF.com. “I see them as a huge opportunity for investors.”
Focus On Cost Can Be Detrimental
The naysayers worry that the excessive focus on costs is not only detrimental to investment outcome over time, but also to the firms themselves, which may not make enough profit to even survive.
“The appeal of companies like Wealthfront to the next generation is as much cost as it is convenience,” Joe Goldberg, wealth advisor with BAM Advisors, told ETF.com. “To set up an account, you watch some online videos and you can do it in a matter of minutes. Going through a full process with an advisor takes time.”
“Unfortunately there are a lot of people who aren’t willing to invest the time even if it could make a significant difference in the amount of wealth they are going to have,” he noted. “They put more value on their immediate time.”
As an investor, here are four things you should know about robo-advisors in general, and what they can mean for your investment experience.
1. They are very low cost, but you need to know what you’re getting for your money.
Investors are keenly aware of costs, particularly since the 2008 credit crisis wiped out so much wealth. They want to pay as little as possible for financial advice as well as for investment vehicles.
Robo-advisors do a stellar job in this regard. Again, Wealthfront’s all-ETF platform, for instance, charges 0.25 percent a year in fees, and thanks largely to that low-cost appeal, the firm has quickly grown to manage more than $800 million in total assets. The firm also offers the service free of charge for accounts under $10,000.
If you go to a traditional flesh-and-bone advisory outfit like Buckingham Asset Management, for example, you would be paying 1.25 percent a year in a tiered schedule that goes down as assets grow. That’s not a negligible difference, particularly if you’re subscribing to a passively managed all-ETF portfolio.
But costs can’t be taken in a vacuum—what you’re getting for your money should be a consideration, Goldberg, of BAM Advisors argues.
“If people’s expectations of what they can get from a financial advisor were higher, these service providers would have less of an appeal,” Goldberg told ETF.com.
“Investors would not be necessarily looking for the lowest-cost solution,” he added. “So many people have such low expectations of what a wealth advisor can provide that advisors really end up looking like a commodity. But in the end, not all wealth advisors provide the same experience.”
Goldberg argues that a true financial advisor acts like an investor’s personal CFO, fulfilling a task that goes well beyond portfolio construction such as accounting and tax advice, but consists of a holistic approach to wealth management that’s worth the cost.
2. They are probably more tax efficient.
Robo-advisors can be more tax efficient in their portfolio construction in terms of the vehicles they use and of locating assets such as IRAs versus taxable accounts, Roth told ETF.com.
Using Wealthfront, again, as an example, Roth said that the firm does a great job at locating assets where they are most efficient. The firm also does what he calls “tax-loss harvesting” by selling a security after a loss and replacing it with a similar security—all in an automated, software-based process.
“For example, let’s say you were in a Vanguard Total Stock Index ETF (VTI | A-100) that lost 20 percent of its value,” Ross explained in a recent blog. “Wealthfront could sell this fund and buy the Schwab Broad Market Index ETF (SCHB | A-100) without waiting the 31 days needed to avoid the IRS wash rule that would void the loss for tax purposes.”
Wealthfront also does this type of tax-loss harvesting at a specific-stock level. This strategy can add annual gains to an investor’s portfolio overtime in tax savings. While it’s not necessarily a novel idea, robo-advisors are the first to put these strategies within reach of every investor for an extremely low cost, Roth says.
3. They rebalance for you, but they can’t protect you from emotional investing.
The rebalancing of your portfolio is automated with a robo-advisor. That’s a good thing because rebalancing is essential in investment management.
“Advisors time markets poorly; I’m not sure robo-advisors would do any worse,” Roth said. “Humans are predictably irrational, whether they’re advisors or consumers. If you can automate the process, you’re harnessing the power of inertia, and that’s a good thing.”
But there are caveats. For starters, your portfolio is practically built based on a survey—which reflects your tolerance for risk, among other things. The problem with answering an automated survey is that you might feel more inclined to take on risk when the market is doing well, but feel far more conservative in bear markets.
If you turned to a robo-advisor, say, in March of 2009, you probably ended up with a portfolio that’s heavily allocated to the safety of bonds, and you would have missed out on the stock rally that followed. So, automation here means you might be starting off with an asset allocation that doesn’t necessarily jibe with your long-term goals depending on how you feel about the market.
Beyond that, robo-advisors might rebalance your portfolio for you, but they won’t stop you from bailing out of your investments in bear markets—a time when many investors get out of the market as they panic.
“We [traditional advisors] earn our fee when times get tough,” Goldberg argues. “There are significant dollars behind the technology of firms like Wealthfront, and they’ve come up with some good technology, but we develop similar algorithmic rebalancing strategies that use high-powered software, but we don’t let the software make the decisions.”
4. Their business model has yet to prove it can stand the test of time.
Many in the industry question whether robo-advisors can last on their own because they just don’t make enough money.
“Betterment, Wealthfront, LearnVest, Personal Capital … there are about two dozen of these organizations, and none of them are going to survive in their current iteration,” Ric Edelman, chief executive officer of Edelman Financial Services, said in a recent interview. “They’re not earning enough revenue to sustain themselves.”
Up to now, Edelman said that these service providers have only been able to sustain themselves through venture capital and private equity funding.
“They’re blowing through tens of millions of dollars in capital,” he said. “It’s very reminiscent of the dot-come ’90s.”
BAM Advisors’ Goldberg suggested that a lot of these companies are at risk of ending up with an 80/20 model where 80 percent of their revenues come from 20 percent of their clients. The problem with that is that in a bear market, investors tend to get out, and as these dollars flow out, robo-advisors would struggle to meet their financial obligations.
Some say the robo-advisory business may have to be less robo, more human to survive.
“I’m not suggesting that the business is a bad business,” Edelman added. “Their technology is very impressive. What they’re discovering is that it takes more than an algorithm to build an effective advisory business.
“Users do want human interaction; they do want advice beyond merely the investment management piece,” noted Edelman. “And most of them are discovering this.”