Robo-Advisors: An Introduction to Online Financial Advice

When Betterment launched its online service in 2010, journalists soon characterized its approach to offering investment advice via a digital interface as “robo-advising.” As other startups entered the space, the field of robo-advisors emerged as an advice-based alternative to do-it-yourself brokerages engaging in the role of a traditional personal financial advisor. Some analysts have also pointed out that robo-advisors build on the success and intuitiveness of automated financial products, like target-date funds, but with a greater degree of personalization, tax features and guidance.

Building a true robo-advisor involves a rigorous, systematic approach to your advice. You can’t give different advice to different people because of how you feel that day or what you think of them. It also means clients get services that are only properly executed using technology, for instance daily tax loss harvesting.

The Basics of What Robo-Advisors Offer: Portfolio Advice

In surveying the landscape of consumer investing today, you might say robo-advisors created a space between do-it-yourself brokerage accounts, like nationwide fund provider firms, and online banks. You can think of each of these industries as a having a core product offering. For online brokers, it’s a trading service; they often earn revenue per trade, margin on any cash you hold, fees from funds for ‘free trades’, and payment for order flow (selling your trades to the best bidder). For fund providers, it’s products like mutual funds or ETFs, charging annual management fees. For banks, they mostly earn money by lending your deposits out as loans.

Instead of selling funds, trades, or deposit accounts, robo-advisors’ baseline offering is a managed portfolio. Using algorithms to define an appropriate allocation of assets based on investor information, robo-advisors provide a portfolio of funds, usually determined by an underlying portfolio model and stock-to-bond allocation advice. To make a recommendation, robo-advisors collect information from the investor, then automatically select an appropriate portfolio from an algorithmic set of possibilities.

The figure above aims to illustrate differences in the types of products offered by investment companies. Self-directed brokerages offer an empty account, ready for you to build yourself. Fund providers offer funds that may be useful in a portfolio (but not necessarily). Betterment and other robo-advisors offer wholly managed portfolios.

To use Betterment as an example, we make our professional portfolio recommendation by asking you about how you plan to use the money (for instance, retirement vs. a house down payment) and how much time you have until each goal. In the background, we offer four different sets of portfolios (which we call portfolio strategies), resulting in 307 possible portfolios. Besides our income portfolio strategy, each of our portfolios are based on Modern Portfolio Theory, which is an approach to portfolio construction that mostly aims to track the global public market performance or be diversified across many risk factors.

Depending on your type of goal and how much time exists until you need to reach that goal, the portfolio will be composed of a different mix of stocks and bonds. Other robo-advisors use a similar approach to this goal-based approach to portfolio advice; although the specific portfolios are likely different. Some robo-advisors provide less personalized portfolio options, such as just four possibilities with loose descriptions: Conservative, Moderate, Growth, and Aggressive.

Green shades represent stock assets while blue represents bonds. At Betterment, your actual portfolios are personalized to your information, so specific allocations may very.

Today, many robo-advisors’ portfolios utilize exchange-traded funds (ETFs), which provide a low-cost—index-based—approach to investing in large swaths of the market. ETFs also provide some operational and trading advantages over other financial products. As Brian O’Connell of TheStreet points out, however, the methodology for how different robo-advisors select ETFs can vary greatly, and may not always be as evidence-based as you might hope. (It’s worth noting, that this isn’t that different from traditional human advisors in most situations).

Some robo-advisors are no longer solely focused on ETFs. Some robo-advisors have emerged that recommend mutual funds or even individual securities from time to time. Betterment, for instance, has long focused on ETFs due to their low cost and tax efficiency, but our approach is based on the evidence of success in index-based ETF investing, not a dogmatic use of the vehicle itself. Some providers like Wealthfront and Personal Capital recommend holding the individual stocks at higher balances for tax or outperformance-seeking reasons.

Solving Do-It-Yourself Investing Challenges with Managed Portfolios and Trading Fractional Shares

Robo-advisors start with wholly managed portfolios for a good reason. Early leaders like Jon Stein and Eli Broverman recognized in the late 2000s that self-directed brokerage accounts created some major issues for investors—even investors who have the know-how to build an optimal portfolio.

The conventional challenge of having to buy and sell whole shares leads to a great deal of manual work—even for the basics of managing a portfolio. To help keep a portfolio on track toward its expected returns, investors usually reinvest dividends (to where they came from), make deposits, and rebalance (based on gains and losses) toward the target allocation of assets in the portfolio.

The challenge is these tasks can become difficult across individual accounts where an investor must trade whole shares and each transaction is charged individually, and it can be hard to track the overall allocation. By combining portfolios with trading fractional shares on investors behalf and no specific transaction fees, robo-advisors aimed to solve the challenges of do-it-yourself investing, while saving investors a great deal of manual work.

At their core, robo-advisors most often automate five major investment tasks that are time-intensive for investors to do on their own:

• Recommending a portfolio of funds. (based on investor information)
• Reinvesting dividends immediately to rebalance.
• Automatic deposits that are invested toward a target allocation.
• Rebalancing the portfolio.
• Adjusting the portfolio’s allocation as an investment horizon nears.

Those tasks alone often reflect enough work, time, and energy that many investors who would otherwise have to self-direct their investments turn to professional help. By automating these tasks, robo-advisors can charge a low fee to save investors a lot of money. As Investor Junkie describes how robo-advisors have changed the retail investment marketplace, “you no longer need a Ph.D. to manage your investments.”

Comparative research (from researchers at N.U.S.T., Financial Engines, and our 2014 behavior gap study) shows that, generally, robo-advised portfolios can outperform self-directed brokerage accounts with similar portfolios simply due to the human factor inherent in managing your own investments.

In accounts with very similar portfolios, per-trade fees often inhibit individual investors from depositing on a recurring basis and investing immediately. The time between depositing (or receiving dividends) and investing into the portfolio’s assets can cause a cash drag on investing returns. Relatedly, when investors wait to invest available cash, their choice of when to trade becomes, in effect, an act of market timing, which has also been shown to be ineffective for achieving higher returns. Learn more about how cash drag affects returns.

A third behavioral factor is rebalancing for the purposes of targeting a specific asset allocation. Investors can, and often do, fail to rebalance their portfolio, which can lead an inappropriate risk profile for the expected returns.

Together, these differences in basic portfolio management can lead to dramatic differences in personal investment returns over time. Robo-advisors have provided an automated way of helping everyday investors avoid such pitfalls without requiring one-on-one investment management services.

Robo-Advisors Aim to Replace Traditional Investment Managers with High Fees

While some investors invariably view robo-advisors as a replacement to self-directed brokerage offerings, like Fidelity or ETrade, others might describe robo-advisors as a low-cost alternative to conventional investment managers, which many consumers might access at their bank or credit union or through a nationwide provider like Edward Jones.

While there may be individual exceptions to the chart above, this figure aims to represent the broad categories of investing services today. New innovation in the space may change the way these operate over time. Nevertheless, we suggest you look more in depth at the companies you are interested in, as they will provide greater detail.

Investors who do not use self-directed accounts may rely on a professional to execute the investment task above (buying a portfolio, reinvesting dividends, depositing toward the target allocation, rebalancing over time, etc.). Often coupled with financial planning or tax services, traditional investment managers usually charge 1% or more for these and additional services, with varying degrees of quality service.

Betterment and others have been particularly critical of investment managers’ tendency to recommend products that focus on the professional’s compensation, rather than the investor’s returns. The independent robo-advisor model of assessing fees on investor assets aligns a customer’s best interest with the way a robo-advisor earns revenue.

Robo-Advisor Portfolios don’t replace professional advice for some complex investors.

While robo-advisors provide investors with advice on their choice of portfolio and how it’s managed over time, many investors with complex lives will still benefit from the level of personalized advice only available from a professional advisor.

This is a major reason why it’s important to draw a major distinction between investment managers—professionals whose services primarily consist of asset allocation, investment selection, and ongoing portfolio management—and financial planners/advisors acting as fiduciaries, who provide planning, coaching, and holistic financial advice in addition to investment management services. While robo-advisors largely replace the basic services offered by investment managers and planners, the guidance available in a one-on-one relationship with a financial advisor, such as organizing an estate, defining how to prioritize complex goals, and arranging insurance, isn’t easily replaced. Often the use of robo-advisor-like technology lets financial advisors spend less time on investments, and more time solving unique client challenges.

The typical investor faces challenging questions about how they want to live their life and what financial resources they’ll need to meet their expectations. There’s enormous benefit to working with somebody who has a practical background for how to plan your finances effectively as well as years of experience helping people work through the reality of managing investments and other financial vehicles.

Some robo-advisors today provide human advisors for those seeking a closer financial relationship. Betterment has led with this approach in two ways: (A) By offering over-the-phone professional guidance through a team of advisors, and (B) by building a network of available local advisors that utilize Betterment’s platform and can provide one-on-one services on top of it. Other robo-advisors utilize a similar approach. In contrast, Wealthfront has emphasized a long-term focus on digital advice without the hybrid approach of having financial professionals available. As the robo-advising field continues to evolve, the question of how much human assistance is needed (or not) to help investors reach their goals is likely to be answered in numerous ways.

Robo-Advisors have opened access to tax-smart investing to any investor.

While most robo-advisors’ core offering continues to be a professionally managed portfolio, leaders in the space have largely been differentiated by their strategic tax reduction services. In general, robo-advisors have aimed to help consumers focus on evaluating performance on a personal, after-tax basis, rather than drawing comparisons to public indices.

For instance, Wealthfront and Betterment each automated tax-loss harvesting—an approach to deferring taxes by accounting for capital losses—in the mid-2010s. Since then, the service has become a basic requirement for most competitive robo-advisors in the space. Today, you can summarize existing robo-advisor tax strategies into six main practices.

1. Selling the most tax-advantaged shares - i.e. “tax lot selection”
2. Optimizing portfolio construction for taxable accounts - e.g. using municipal bonds
3. Organizing assets by taxability into different account types - i.e. “asset location”
4. Harvesting capital losses to carry forward on taxes - i.e. “tax-loss harvesting”
5. Donating capital gains to charity

Preventing unnecessary sales that result in taxable gains - i.e. tax-aware rebalancing and giving customers a preview of tax consequences before a sale. Historically, only very wealthy investors have had access to tax-smart strategies like asset location or tax-loss harvesting because such tactics have long required detailed manual execution by a professional. By automating professional strategies that keep the impact of taxes at bay, robo-advisors help investors keep more of their returns after taxes.

Depending on the service, you may find variations how each of these five tactics is executed, but generally, the list above represents the tax strategies that robo-advisors have pursued. For instance, Betterment has focused on offering services for all six areas. Meanwhile, Wealthfront has improved upon baseline tax-loss harvesting by offering stock-level harvesting for accounts above a certain minimum. With variations in how tax strategies are implemented, it’s important to carefully evaluate how different services have built their automated tools.

Looking back, traditional financial advisors can be admired for their fiduciary approach and customer-centric mindset, but they weren’t serving the needs of a large majority of Americans. Meanwhile, brokers and fund providers were too often setup to hawk products on investors and have them churn accounts, instead of focusing on what would make clients better off.

Robo-advisors have changed some of this.

For low fees and sometimes no minimum balance, robo-advisors have changed how portfolio advice and management works for any American that wants it. On top of that, some robo-advisors have made major inroads toward helping investors take home more of their investment returns, by improving and automating tax-smart technologies. These advancements are true game-changers for Americans who may not have been able to access financial advice in the past. Traditionally, only the wealthiest investors had evidence-backed investing strategies (see our example) aligned to their personal best interests; today, many more Americans can access fiduciary investment advice that is thoroughly researched and fully managed.

Robo-advisors emerged because consumers looking to invest were being underserved. Now, leaders like Betterment are elevating the entire marketplace of financial advice.

Serving individual investors directly and working with financial advisors, you can find robo-advisors today automating and delivering more personalized guidance, more customizable portfolio options, and specialized tools that help improve investor behavior.

Betterment is leading in robo-advisor space, but we’re not the only option. We encourage you to survey the landscape. Explore whether you’re looking for a one-on-one professional relationship, and learn about some of the misconceptions within the robo-advisor industry today. If you have questions, we’re only an email away.