What’s a robo-advisor, and should I have one?
If you’ve been hearing more and more about robo-advisors lately, that’s no surprise. First offered in the United States, robo-advisors have spread to the rest of the world, and are now one of the hottest ways of managing money for the average investor. In 2018, over $225 billion in assets were managed by robo-advisors worldwide.
A little bit of history…
For such an important development, the history of robo-advisors is surprisingly short. They were first brought to market in 2008, in the wake of the financial crisis. Recognizing that investors’ faith in their advisors had been shaken, startup entrepreneurs saw an opportunity. Why not offer the average investor access to the same technology for managing portfolios that professional advisors were using—without charging them hefty fees? By repackaging the technology and bringing it to the market under the catchy name of “robo-advisor” they gave birth to a whole new financial service.
Why so popular?
The rapid growth of robo-advisors is testament to the growing belief that, over the long term, most investors rarely outperform the market. Add in the high fees charged by professional financial advisors, and many investors would do better simply by investing in index funds.
And history seems to bear that out. According to the Globe and Mail in 2016, “the number of Canadian funds focused on U.S. large-cap stocks that outperformed the index over the past five years was precisely zero”. And the Financial Times reported that 99% of U.S. equity funds and nearly 97% of emerging market equity funds failed to outperform their benchmarks in the 10 years between 2006 and 2016.
Even Warren Buffett, the all-time heavyweight champion of stock picking, has joined the side of index funds. In his Annual Letter to Shareholders, Buffett said that the average investor is better off just sticking with a passive investment strategy: “The goal of the non-professional should not be to pick winners…Put 10% [of your portfolio] in short-term government bonds and 90% in a very low-cost S&P 500 index fund. I believe the long-term results from this policy will be superior to those attained by most investors…who employ high-fee managers.”
How do robo-advisors work?
Until recently, the average investor who wanted to follow Buffett’s recommendation had to manage their portfolio themselves. That meant figuring out your risk tolerance, determining your overall financial needs and retirement plans, and then—based on that profile—deciding how much money to allocate to equities and how much to bonds.
Once that was done, you would have to sign up with a discount brokerage and choose the suitable index funds to create an appropriate asset allocation. Following that, every six or twelve months, you would have to review your portfolio and rebalance it. That’s because, over time, the ratio of equities to bonds in a portfolio always drifts away from what you originally selected.
However, with the advent of robo-advisors you no longer have to do all that work—the robo-advisor does it for you. First, robo-advisors determine your personal profile by asking all the same questions a professional wealth manager would ask. Such things as what is your age, and when do you hope to retire? How many dependants do you have, and are they planning on higher education? If the market dropped by 25% over the next six months, would you still be able to sleep at night?
Using this information, the robo-advisor determines the best asset allocations and selects the actual funds for your portfolio. In almost all cases, these will be ETFs—(exchange traded funds) that are very low-cost funds of equities or bonds. And best of all, the robo-advisor will also take care of the regular portfolio review, and will regularly rebalance your portfolio so that your investment allocation stays aligned with your long-term objectives.
The benefit for individual investors
Robo-advisors should be seen as a halfway step between having a wealth manager and going out completely on your own. It’s certainly true that a robo-advisor won’t sit down and have coffee with you, or hold your hand through a really rough time in the stock market (although some robo-advisor services do offer limited advice sessions online and over the phone). But on the other hand, they will provide you with the same kind of portfolio management as a personal wealth manager—they’ve simply automated the process. And, just as you do with a professional, you can check in with your robo-advisor whenever you want to update your profile and input new life events, like a marriage, the birth of a child or the purchase of a new home.
The big difference? Fees. The fees that professional investment advisors charge for their services can vary widely, but they are often within the range of 1.5% to 2.5%. Robo-advisors solve that problem, because they can cut those fees by 50% or more, all while providing professional money management and keeping your investments on track.
Robo-advisors are best for investors who have a comparatively simple financial profile, don’t require a lot of reassurance through the ups and downs of markets, and are content to park their money and let it grow. You can also split up your portfolio, so that part is passively managed by a robo-advisor, and part is actively managed by a personal wealth manager.
If you’re thinking of engaging a robo-advisor to manage your money, check out —(this article from Money Sense, which lists several robo-advisors available in Canada.
Emerging competition for robo-advisors
Recently, a Canadian investment firm announced a new online wealth management service designed to compete directly against the current crop of robo-advisors. The company claims their approach will offer all the benefits of automated robo-advisors, but at a significantly lower cost.
Like the established robo-advisors, you must provide the service with your overall investment objectives, together with details including your age and number of dependants, as well as your overall risk tolerance and appetite. Portfolio managers will then develop a portfolio to support your goals, but once created, algorithms then take over the day-to-day management of your portfolio.
This new form of automated portfolio management follows the same approach. However, where it differs is that rather than including multiple holdings in your portfolio and charging fees for each holding, you’ll have a single holding and a single reduced fee for managing your portfolio.
The investment firm can achieve this by creating an ETF which is itself comprised of several underlying ETFs. This makes it possible to set up a single holding that still provides you with an appropriate mix of assets across your entire portfolio. Once established, algorithms will continuously auto-balance the ETF to ensure that your asset mix remains suitable, and takes into account changing market conditions.
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