The rise of the robo-advisor represents one of the most profound shifts in FinTech. It also raises legitimate concerns about whether algorithms will soon replace traditional financial advisors as investors and financial institutions both look for more cost-cutting advantages.
As we’ve seen in various other sectors, the “robots are taking our jobs” narrative isn’t so cut-and-dry. That’s because the cost savings associated with automation lead to greater profitability, which in turn creates more employment opportunities for businesses that invest in new technology. That being said, robo-advisors are growing in popularity as investors seek better performance. For that reason, they have a profound impact on the future of asset management.
A robo-advisor is an automated online tool that provides investment solutions, money management services and portfolio management to traders and institutional investors. More sophisticated robo-advisors are also capable of executing trades and minimizing taxes.
Robo-advisors and other algorithm-based software are offered by leading investment brokerages and online platforms specializing in retail trading. Two of the most-recognized robo-advisors are Wealthfront and Betterment, which collectively have billions of dollars in assets under management. As investors have no doubt noticed, robo-advisors have advantages and disadvantages when compared to traditional asset managers.
Robo-Advisors Versus Traditional Asset Managers
Investors on the prowl for lower fees and simplicity typically find algorithm-based programs highly attractive. The growth and widespread adoption of do-it-yourself investing has also boosted demand for robo-advisors and allowed investment services to become democratized across a wider audience. Automated software programs allow DIY investors to increase their exposure to the financial markets across a range of asset classes.
In addition to cost savings and greater access, robo-advisors may also provide better performance than traditional asset managers because they leverage more powerful technology to deliver investment services. This means taking into consideration a myriad of real-time variables that a traditional asset manager may not be able to track.
However, robo-advisors offer several disadvantages. Despite being automated, they offer little guarantee of success, and asset selection is typically much more limited in comparison to more conventional investing programs. Additionally, robo-advisors will never be able to offer advice on personal financial questions that are unique to your specific situation. And because robo investing is still in its early stages, not all programs are reliable or effective. The phrase “you get what you pay for” certainly applies to this rapidly expanding market.
By comparison, traditional asset managers pick up where their robotic counterparts leave off in terms of personalized financial advice and a greater selection of investment strategies. While more expensive than computer-based algorithms, asset managers are often paid on commission, which means their earnings are tied in part to the success of your portfolio.
Aside from the obvious costs associated with asset managers, other disadvantages with going down the traditional route include less flexibility to compare services and more stringent requirements to work with the best advisors. Top-notch advisors typically have a minimum balance requirement that investors need to bring their portfolio under management.
A careful look at the advantages of robo-advisors makes it clear that these programs are targeted toward fee-adverse investors who may not have the time or skill to manage their own accounts. Studies have shown that self-directed investors typically underperform the market, leading to overtrading, panic selling and herd mentality. These are the behavioral pitfalls of every unsuccessful investor. As the market for DIY investing continues to grow, robo-advisors will likely experience greater uptake.
Financial Management Industry Implications
Algorithm-based investing will have direct implications on the traditional financial management industry. Not only is the traditional financial advisor model changing, but service, distribution and marketing efforts are also undergoing a shift. Traditional advisors and financial management services must therefore generate higher returns than ever before to attract new investors or reduce costs dramatically to compete with computer-driven platforms.
Against this backdrop, it’s easy to see the benefits of robo-advisors from the perspective of investors. Lower fees and the ability to manage an investment portfolio remotely offer a large degree of flexibility and opportunity. However, robo-advisors cannot do everything, and this includes helping investors manage their emotions. Therefore, investors going down the robo route should be prepared to develop a solid understanding of risk management and behavioral finance to avoid emotional blunders that often lead to failure.
From the perspective of financial advisors and asset managers, robo-advisors offer greater competition, which often leads to innovation in traditional service industries. In this environment, financial advisors may benefit from marketing personalized services that robotic trading platforms simply cannot duplicate. At the same time, however, financial advisors and asset managers must find ways to reduce costs and boost performance to appeal to a wider audience of investors who are no doubt attracted to the affordability of algorithm-based trading.
Asset Managers Counterattack
Asset management firms such as Schwab, Vanguard, WisdomTree and Fidelity have rushed to launch their own robo-advisor programs, a sign that algorithm-based investing will become more specialized over time. For instance, Charles Schwab released its robo-advisory platform, Schwab Intelligent Portfolios, in 2014, and Vanguard released its robo-advisory platform, Personal Advisor Services, in 2015. These and other asset management firms have taken different approaches to robo-advice, but each seeks to capitalize on the growing demand, including offering stand-alone robo-advisors, partnerships, discount broker robo-advice and full-service e-advisor capabilities.
This bodes well for the industry, and will likely pave the way for a more sophisticated and competitive market over the next five years as asset management firms introduce both stand-alone and hybrid services. It’s the latter than is generating the most excitement. By pairing robo-advice with human advisors, hybrid models benefit from reduced costs and personalized services. This model may serve to overcome many of the existing challenges impeding today’s computer-generated investment services. To find out more about Schwab’s Intelligent Portfolios, read “It’s Not Sci-Fi, it’s AI: Schwab Intelligent Portfolios”.
Robo-advisors are new entrants in the exchange-traded fund (ETF) industry, but have made an immediate impact. Many algorithm-based programs recommend portfolios that consist of low-cost index funds that track ETFs, offering investors wider exposure to the market. In fact, many critics of robo-advisors argue that these programs do little more than recommend top ETFs, so while investors will certainly benefit from ETF picks, their profiles won’t differ greatly from other investors who are also leveraging robo-advisors. Read “ETF Friendly Robo-Advisors” for more information.
For a deeper analysis on individual ETF investments, use our ETF Analyzer Tool. You can select ETFs by category or type, as well as add individual ticker symbols to compare performance, expenses, and dividend yield among other metrics.
The Bottom Line
We may be on the cusp of a major breakthrough in the robo-advisor market, as the world’s largest asset managers rush into this emerging space, bringing with them new innovations and service delivery models. This evolution will bring both rewards and challenges to the broader ETF market.
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