Are Robo Advisors a Dawn of a New Era?
First the digital disruptors came for the taxi and hotel industries. Now they’re coming for the bigshot money managers.
Unless you’ve been living under a rock for the past few years, you can’t have missed the trend to cheaper online app-based alternatives in a variety of industries. The world of traditional investing will have to adapt or perish as low-fee online investing platforms known as robo advisors have exploded onto the scene.
Robo advisors are essentially a low-fee alternative for financial advisers and investment management firms. Financial advisers charge around 1% in fees annually. Actively managed equity mutual funds have a similar expense ratio, and their hedge fund brethren charge their clients using the “2-and-20” rule of thumb. (Two and twenty referring to a set 2% in fixed annual fee combined with an additional 20% clawback on all profits above a certain threshold.) By comparison, robo advisors can charge 0.5% or less annually because they rely on passive investing methods and cutting the costs involved with brick-and-mortar banking.
More and more people are starting to realize that these investment fees play a significant role in their long-term finances. A young investor that starts with a portfolio of $10,000, and contributes $10,000 each year, with a 5% annual rate of return, will end up with approximately $741,000 at the end of 30 years. Subtract just 1% in adviser fees each year, and your net value will drop by $130,000. Subtract the 2% a hedge fund might charge, and you’ll be set back an additional $100,000!
Now, your financial adviser might claim that they are more than worth their 1% because with their help your investments will do much better than the average. The fact is however, that passive ETF investing has proven to fare better than actively managed mutual funds in essentially every type of investing environment over the long term. Even the famous investor Warren Buffett believes that passive investing trumps the actively managed alternatives that the financial services industry thrives on. Nine years ago Mr. Buffett put his money where his mouth is and challenged the hedge fund industry to a friendly wager, betting a million dollars that his basic index ETF would beat any fancy portfolio of hedge funds they could come up with. Mr. Buffett not only won – it was a rout!
Numerous academic studies have consistently proven that high-cost mutual funds have underperformed against their respective benchmarks. The math doesn’t lie – retail investors are simply much better off with a index portfolio of cheap ETFs. The most efficient way to build wealth is to decide what sort of overall asset allocation (domestic stocks, foreign stocks, bonds, etc.) that you want based on your investment goals and risk tolerance – then simply purchase a DIY portfolio of basic index ETFs and rebalance your allocations monthly.
That being said, this cost-cutting extreme is not for everyone. Many of us simply don’t have the expertise, time, education, or patience to manage our own portfolios. Even an ultra-cautious, highly-passive investment portfolio requires some adjustments every once in a while, and those who are inexperienced at it may find it overwhelming. Robo advisors seek to help the investor that is cost-conscious, but doesn’t want to worry about spreadsheets as they save for retirement or a new house. Their value proposition is easy to understand: great advice delivered through your computer, combined with a superior index-based investment approach, all for less than half of what a traditional financial advisor would charge.
Robo advisors are increasing their foothold in the market with each passing year. Even our tiny nation already boasts more than 1bn Shekels invested through robo advisors. In financial-technology (“fintech”) friendly markets such as the USA, $266,000,000,000 are already managed by robos, and it is predicted to grow 4-fold in the next 5 years! Even large banks such as JP Morgan, Bank of Montreal, Deutsche Bank and Wells Fargo, that were built on the traditional financial advice model, l are taking their piece of the growing pie by starting their own robo advisors.
If you’re still worried about trusting something called a “robo” with your money, consider that basic algorithms, data analysis, and rudimentary artificial intelligence breakthroughs have shaken up traditional industries all around the world – why should financial systems be immune? Financial advisors are subject to the same limitations that any human-based service are. Consider the incentives involved for financial advisors who get paid based on how many clients they can process, and how efficiently they can shift money from your bank account to their investment selections. In many cases these investment selections are simply house mutual funds that maximize revenue for the parent company and may not be in the client’s interest at all. Robo advisors on the other hand don’t feel fatigue and have no incentive to rush you through the investment selection process. Their paycheque doesn’t change based on what investments they recommend.
When you start with a robo advisor you can patiently answer a questionnaire designed to thoroughly understand who you are, what your investment goals consist of, and generally how you respond to risk with your money. Based on your answers, algorithms can quickly match you with a portfolio that matches your needs and risk profile. Before you actually invest any of your money of course you can always consult a qualified professional via email, text chat, phone call, or online video. Ultimately, once you determine what your asset allocation should be, the robo advisor will automatically rebalance your investments, thus keeping your investment profile in sync with your changing financial situation and investment horizon. All investors need to worry about is keeping up that nice healthy savings rate, and the efficient technology behind the robo advisor will take care of buying and selling the index ETFs that will grow your nest egg.
With an investment philosophy that is proven to outperform traditional mutual funds over the long haul, user-friendly online interfaces, a transparent process, expert advice, and drastically lower fees, robo advisors are poised to grow at an exponential rate. As more and more people understand the significance of investing fees, combined with the generational push towards trust in technology and artificial intelligence, the rise of the robo advisor appears to be simple as demographics and math.