Most people who do any investing at all have heard about robo-advisors and at least know that they are basically computer software designed to make investment decisions for them. But knowing what they are and understanding how robo-advisors work are two different things.

Understanding how robo-advisors work can help make the decision whether or not to use one a bit easier.

Charles Schwab found that nearly 60% of Americans expect to use some type of robo-advice by 2025. According to Statista, this year robo-advisors manage about $750 billion in assets. The firm estimates that nearly 14 million investors will be using robo-advisors by 2023.  

What are robo-advisors?

Put simply, robo-advisors are online services that enable investors to make choices about where to put their money. They provide a mostly hands-off way to manage wealth because computers do the heavy lifting.

Betterment was the first robo-advisor. It launched in 2008 and began accepting money from investors two years later.

Even investors who don’t know much about investing but want to get their money working for them can generally figure out how to make robo-advisors work for them. This is true even for investors who don’t understand how they work.

The beautiful thing about how robo-advisors work is that they are automated and require little or no supervision. Investors simply give the service access to their money, enter data for parameters and hopefully, start watching their money grow.

But how do robo-advisors go about actually managing money? It all boils down to computer algorithms.

Algorithms are what computers use to solve problems. The algorithms used by robo-advisors are designed to solve the problem of which assets or funds to include in a client’s investment portfolio.

Algorithms are designed to offer an efficient and cost-effective way to manage a portfolio. Computers decide where to put a client’s money based on the data they entered when setting up their account.

Some would argue that computers are better than humans at choosing investments based on best practices and data alone.

Robo-advisory services use their own algorithms to build portfolios for investors who use their platform. The algorithm takes into account whatever the investor has entered when setting up their account.

Each algorithm varies according to how the firm has set it up. In other words, different robo-advisors may turn out different results for the same sets of data entered.

Robo-advisors offer a number of different automated services ranging from portfolio construction to automatic rebalancing, tax optimization and more.

How robo-advisors work: under the hood

Every robo-advisor is different, and they all utilize their own proprietary algorithms. For this reason, it can be difficult to get a complete understanding of how they work.

Firms generally keep details about their algorithms under wraps. However, there are some similarities that explain how such services operate.

Perhaps the most important is the methodology behind all those algorithms. In a post for LinkedIn, Raffaele Zenti of Virtual B said he conducted heavy research into the methodologies used by robo-advisors to construct portfolios.

He studied white papers and documentation published by the operators of about 50 different robo-advisors. He found that more than 40% of them use Modern Portfolio Theory to construct their customers’ portfolios.

That was the most popular basis for building portfolios used by robo-advisors, although other options like qualitative and quantitative data are also used.

The average investor may not have heard of Modern Portfolio Theory. It describes how risk-averse investors can build portfolios to maximize their returns based on a predetermined amount of market risk.

Modern Portfolio Theory views the potential risk and return of every investment together. It assumes that investors prefer less risky portfolios over riskier ones and that they will only accept more risk if the expected reward is greater.

Questions, questions…

While algorithms drive robo-advisors’ selections for client portfolios, it is the humans behind them whose views are reflected in the actual selections of assets. Robo-advisors base their decisions on the data entered by investors at the time they set up their accounts.

This data is gathered from investors via a questionnaire. It includes basic questions such as the investor’s age and the amount of time they will be investing.

The questionnaire will also include questions about the investor’s goals. The portfolios of investors with long-term goals will look quite different than those of investors with short-term goals.

Additionally, younger investors can typically take on more risk than older investors because they should have more time to make up any losses that come their way.

Robo-advisors also typically ask about investors’ risk tolerance and then assign risk levels which can range anywhere between conservative and aggressive. Investors with a greater tolerance for risk will usually end up with a more aggressive portfolio than conservative investors.

Generally, aggressive portfolios feature investments with a high risk and high potential reward. On the other hand, conservative portfolios contain mostly low-risk, low-reward investments.

Additionally, conservative portfolios are generally geared more toward bonds, which carry less risk, while aggressive portfolios focus more on stocks.

What’s in a robo-portfolio?

Most robo-advisors choose only from exchange-traded funds. ETFs offer an easy way to diversify, even for investors who don’t go the robo-advisor route. Not only is each individual ETF diversified, but the computer algorithm adds further diversification by choosing from a variety of different funds geared toward specific investment types.

For example, an investor with a moderately aggressive portfolio will typically be angled toward a 60% stock allocation and a 40% bond allocation. Extremely aggressive portfolios may target allocation that’s 90% stocks and only 10% bonds.

However, such portfolios are only advised for young investors with a lot of time to make up for potential losses.

Robo-advisors can also break down these allocations further by designating a set percentage of the stock allocation to be put toward large caps, small caps or emerging markets. They then use these allocation targets to pick ETFs or other assets to include in the portfolio.

For example, some ETFs may target small caps by indexing with the Russell 2000, while others may target large caps by tracking the S&P 500.

Many ETFs are passive funds that are benchmarked to a particular index like the S&P 500. This is why they are so well-diversified.

Some examples of ETFs that are commonly included in portfolios selected by robo-advisors include the SPDR S&P 500 ETF and the iShares Russell 2000 ETF. Other selections include the Vanguard FTSE Emerging Markets ETF and the iShares iBoxx & Investment Grade Corporate Bond ETF.

Included services

One other thing that’s important to know about how robo-advisors work is which services most of them include. They typically set up the investor’s portfolio initially, but the services don’t stop there.

Another important part of investing is rebalancing the portfolio. Over time, allocations will shift as one particular asset class does better than the others. This pulls the allocation in favor of the outperforming asset classes because they are gaining more money than the others.

Robo-advisors will rebalance the portfolio automatically by selling assets in one class and buying other asset classes. Some rebalance at set intervals like every quarter, while others do it more often.

Once again, they use computer algorithms to perform the rebalancing. Each allocation is assigned a set range like 25% to 35%.

Whenever the percentage moves outside that range, the robo-advisor rebalances the entire portfolio.

Services that manage taxable accounts usually also offer tax-loss harvesting and other strategies aimed at reducing the investor’s tax burden. Under tax-loss harvesting, robo-advisors automatically sell assets that have generated a loss for the investor and then buy a different asset of the same class.

For example, if the S&P 500 declined over the course of the year, the platform will sell one of the S&P ETFs. It will then buy another ETF that tracks the same index.

The purpose is to offset the capital gains tax recorded on another asset that’s similar to the one that was sold. Tax-loss harvesting is aimed at limiting the recognition of capital gains in the short term by locking in losses.

Some robo-advisors offer limited access to a human financial advisor with lower fees than those that are usually charged by traditional wealth management services. Online planning services are sort of like a hybrid between traditional wealth management and robo-advisors.

For this reason, they may have higher account minimums and slightly higher fees. However, the fees will still be lower than those charged by traditional financial advisors and planners.

Some examples of these hybrid services include Charles Schwab Intelligent Portfolios Premium and Vanguard Personal Advisor Services.

Advantages and disadvantages

As with all investment strategies, robo-advisors come with advantages and disadvantages. They may be the perfect solution for one situation but not for another.

One of the primary reasons why investors choose robo-advisors is to save money on fees and management costs. Investing using algorithms is much cheaper than hiring a human to do the work. Computers work efficiently and automatically without taking up a human’s time.

Investors can expect to pay most robo-advisors between 0.2% and 0.5% of their total account balance every year to manage their portfolio. On the other hand, typical fees for human financial advisors are often in the neighborhood of 2% or 3%.

Human advisors also often charge a transaction fee on trades, while robo-advisors typically do not because they rebalance automatically. Accounts that are based on commission come with even more fees.

Human advisors who are paid on commission may also be more inclined to favor funds that offer them a commission over those that don’t. Robo-advisors face no such bias.

Another big reason investors choose to work with a robo-advisor is if they don’t have a lot of money to invest. Human financial advisors typically require a nest egg of at least $100,000 or even more in some cases.

However, robo-advisors usually have very low requirements, making it easy for almost any investor to get started in the market.

Investors access their robo-advisors online, so it’s also easy to make changes to portfolio allocations. With human advisors, it may take longer to make changes, so robo-advisors tend to also be more efficient.

There are some issues with robo-advisors as well. The most obvious limitation is in the assets available to choose for any portfolio.

Investors aren’t free to make their own choices about where to invest their money. They are limited to whatever assets or funds their robo-advisor chooses from.

They also can’t choose from among the funds their robo-advisor offers. They’re stuck with whatever the platform chooses for them based on the data they entered.  

To use—or not to use—robo-advisors

Every investor must decide on their own whether a robo-advisor is right for them. It’s an easy question to answer for those who don’t have very much in assets to invest.

Traditional wealth managers won’t take on their accounts, so robo-advisory services are the only option. Investors who do have enough for traditional financial advisory services will have more considerations to make.

Investors who like the idea of managing their own portfolio but lack the knowledge to do so may find a robo-advisor to be an excellent middle ground. Such services enable them to learn the basics of investing.

Investors whose investment strategies are simple may also find robo-advisors to be good options. On the other hand, those who follow complicated strategies may prefer the services of a human advisor.

Choosing a robo-advisor

Those who opt to use a robo-advisor then must study the many options that are available. Some options even offer zero management fees, but their tools may be more limited than those that do charge small fees.

Investors should also consider the type of account they’re planning to open, whether it’s a taxable account, IRA or 401(k).

Some robo-advisors go beyond the basic services of allocation, rebalancing and tax-loss harvesting to offer additional services.

For example, investors who plan to open a taxable account may be interested to know about Wealthfront’s direct indexing option, which is available to those with $100,000 or more to invest. Direct indexing enables investors to invest directly in individual stocks or bonds rather than through an ETF or other fund.

This can be beneficial when tax time rolls around. Betterment, one of the oldest robo-advisors around, offers additional tools aimed at helping investors achieve their goals.

When it comes to choosing a service, understanding how robo-advisors work and the services and tools they offer can go a long way.

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