Robo advisors are digital platforms that serve as providers for automated, algorithm-driven financial planning services. Human supervision requirements for robo advisors are typically little to none. Robo advisors accumulate information from their clients through a survey which discusses their financial situations and investment goals. The robo advisor utilizes that info to provide advice and invest the different assets provided by the clients. A great robo advisor should have the following features: easy account setup, robust goal planning, account services, portfolio management, and security measures , attentive customer service, comprehensive education, and low fees.
What is a robo-advisor?
Robo advisors are software products that can help you manage your investments without the need to consult a financial advisor or self-manage your portfolio. You usually open a robo-managed account and then supply basic information about your investment goals by filling an online questionnaire. After you supply your information, robo advisors crunch the data to provide an asset allocation approach and build a portfolio of diversified investments for you that meets your target allocation percentages for those investments.
A robo-advisor is technically not an advisor, nor is its role limited to a single activity. Rather, it describes any number of online platforms that track investment trends, follow an algorithm designed for a client’s portfolio preferences and recommend opportunities to save or invest.
While “robo-advisors” might sound like something out of a sci-fi flick like Terminator, these technology based financial tools don’t have anything cheesy about them. Nor are they novelty tools which are used by a few experimental users. In the year 2017, robo advisors managed over $200 billion in client assets.
Understanding Robo Advisors
The first robo advisor launched in 2008 and began taking investor money in 2010, during the worst phase of the crippling recession. Robo advisors’ initial purpose was to rebalance assets within target-date funds for investors to manage passive, buy-and-hold investments with the help of an easy online interface. The technology itself was nothing new. Human wealth managers have been using automated portfolio allocation software since the beginning of the new millennium. But until 2008, they were the sole ones who could buy the technology, so clients had to use a financial advisor to profit from the innovation. In the present, most robo advisors utilize passive indexing strategies that are optimized using some variant of the Modern Portfolio Theory (MPT). If you have specific investing needs such as Halaal investing or socially responsible investing, robo advisors can provide optimized portfolios for them as well.
The advent of recent robo advisors has completely changed that narrative by delivering the service straight to consumers. With a decade of development behind them, modern day robo advisors are not just for rudimentary tasks anymore. They can handle sophisticated stuff such as tax-loss harvesting, investment selection, and retirement planning. The industry has experienced explosive growth as a result; client assets managed by robo advisors hit $60 billion at the end of 2015 and are projected to go beyond US$2 trillion by 2020 and $7 trillion worldwide by 2025.
Robo advisors are known by many different names worldwide. Some of the commonly used synonyms are “automated investment advisor,” “automated investment management,” and “digital advice platforms.” All of the names refer to a shift in consumer behaviour towards fintech (financial technology) applications when it comes to managing their investments.
How do robo-advisors work?
Because these advisors are software based tools, you’ll typically fill out a financial questionnaire to help “program” that software with your investment preferences.
Your preferences can include:
- Your personal risk tolerance. You specify whether you’re looking for high-risk investments or prefer lower-risk opportunities.
- Your age and investment timeline. If you’re a 22-year-old college student, you’ll have much different financial needs than, say, a 60-year-old who’s ready to retire.
- Your retirement goals. Aiming to be a millionaire by retirement? Feed this information in your robo advisor’s questionnaire so that it can plan how to get you there.
- Your current portfolio information. Folding in your current investments results in a fully informed advisor — and decisions that successfully align with your goals.
Portfolio Rebalancing with Robo Advisors
The majority of robo advisors utilize modern portfolio theory (or some variant) so as to create passive, indexed portfolios for a wide variety of users. Once established, robo advisors still monitor those portfolios to make sure that the optimal asset class weightings are maintained even after the markets move. robo advisors achieve this by using rebalancing bands.
When the load of anybody’s holding jumps beyond the allowable band, the whole portfolio is rebalanced to reflect the initial target composition.
In the past, this sort of rebalancing has been frowned upon because it used to be quite time consuming and generate transaction fees. However, with robo advisors this is often both automatic and inexpensive.
Another type of rebalancing commonly found in robo advisors—and which is made cost-effective through the use of algorithms—is tax-loss harvesting. Tax-loss harvesting as a strategy involves selling securities at a loss to offset capital gains liabilities within a similar security. This strategy is usually employed to reduce the recognition of short-term capital gains. To do this, robo advisors will maintain a stable of two or more ETFs for every asset class. So, if the S&P 500 loses value, it will automatically sell that one to lock in a capital loss while at the same time buying a different S&P 500 ETF. robo advisors must take care to pick the acceptable ETFs and backup ETFs in order to avoid a wash sale violation.
Benefits of Using robo advisors
The main advantage of robo advisors is that they’re low-cost alternatives to traditional advisors. By eliminating human labor, online platforms offer equivalent services at a fraction of the value. Most robo advisors are quite economical, charging as low as an annual flat fee which comes up to just 0.2-0.5% of the total account balance. That compares very favourably with the standard rate of 1 to 20% charged by a person’s financial planner (and potentially more for commission-based accounts).
robo advisors are also more accessible. They are available 24/7 for users with a good internet connection. Furthermore, it takes significantly less capital to get started, as the minimum assets required to register for an account is typically in the hundreds to thousands ($5,000 is a standard baseline). Quite a few robo advisors don’t require a minimum account balance.
In contrast, human advisors don’t normally manage the holdings of clients with less than $100,000 in investable assets, especially those that are established within the field. They prefer high-net-worth individuals who need a spread of wealth management services and have the financial strength to buy them.
One of the other big advantages of robo advisors is their efficiency. For instance, before robo advisors, if a client wanted to execute a trade, he/she would need to call or physically meet a financial advisor, explain their needs, fill out the paperwork, and wait. Now, all of that can be done with the click of a few buttons within the comfort of one’s home.
Conversely, employing a robo advisor will limit the choices that you can generally make with ease as a private investor. You cannot choose which mutual funds or ETFs you are invested in, and you cannot purchase individual stocks or bonds in your account. Still, picking stocks or trying to beat the market has been shown time and again to supply poor results , and ordinary investors are often more happy with an indexing strategy.
Hiring A Robo Advisor
Opening a robo advisor will often entail taking a short risk-profiling questionnaire and an evaluation of your financial situation, time horizon, and subjective investment goals. You will have the chance in many cases to link your checking account directly for quick and straightforward funding of your robo advisory account.
The hallmark of automated advisory services is their simple online access. But many digital platforms tend to draw in and target certain demographics quite unlike others. The younger, tech savvy generation such as the millennials and Gen Y are heavily dependent on technology for everything. So it only makes sense that they will be very willing to use technology for managing their investments as well. This population is far more comfortable with sharing personal information online and entrusting technology with important tasks, like wealth management. Indeed, much of the marketing efforts of robo advisory firms employ social media channels to succeed among the younger customer demographic.
Still, the industry is garnering increasing interest from baby boomers and high-net-worth investors also, especially because the technology continues to get better every day. Recent research by Hearts and Wallets shows that half of the investors aged 53 to 64, and one-third of retirees, use digital resources to manage their finances.
Robo Advisors and Regulatory Authorities
In the eyes of regulatory authorities, robo advisors hold the same status as human advisors. They must register with the Securities and Exchange Commissions of a given country to conduct business, and are therefore subject to similar securities laws and regulations as traditional broker-dealers. Officially, it’s known as Registered Investment Adviser or RIA as an acronym. Most robo advisors have a membership in the Financial Industry Regulatory Agency (FINRA) as well. Investors can research robo advisors in the same way they might check on a personal advisor .
How Robo Advisors Make Money
The primary way that the majority robo advisors earn money is with the help of a wrap fee on the supported assets under management (AUM). While traditional (human) financial advisors typically charge 1% or more per annum of AUM, most robo advisors charge around just 0.25% per annum. They are able to charge lower fees because they use algorithms to automate trades and indexed strategies that utilize commission-free and low-cost ETFs. However, since they charge lower fees, robo advisors must attract a large quantity of smaller accounts so that they can match the revenue generated by a more expensive personal advisor.
Aside from the standard management fees, robo advisors make money through other avenues as well. One way is with the help of the interest earned on cash balances (“cash management”), which is credited to the robo advisor rather than the client. Since many robo-advised accounts only have very little allocation to take full advantage of their portfolios, this will only become a big source of income if they need many users.
Payment for order flow forms another revenue stream for robo advisors.Typically, robo advisors will accumulate funds that have been added from deposits, interest, and dividends and then bundle these together into large block orders executed at just one or two points in a day. This allows them to execute less trades and get favorable terms due to the large order sizes. Many times, these blocks will be directed to particular liquidity providers such as high-frequency trading shops or hedge funds in return for rebates which are paid to the robo advisor.
Finally, robo advisors can earn money by marketing targeted financial products and services to its customers such as mortgages, credit cards, or insurance policies. These are often done through strategic partnerships instead of the utilization of advertising networks.