After the 2008 financial crisis, a new form of automated investment service burst into the public sphere. Robo-advisors — a not-so-clever portmanteau of robot and advisor — offer algorithm driven financial advice and portfolio management for shockingly low fees.
These digital denizens aren’t your usual financial service. These new robot overlords continue to draw massive investments. Your mother, neighbor, best friend, and other non-trading relations are plowing their hard-earned dollars into the future of investing.
As an astute and informed trader, you may be wondering: Just what is a robo-advisor and should I care? Read on to find out.
A robo-advisor is a digital platform that algorithmically designs and manages a portfolio of assets, all with little to no human intervention. This is usually accomplished by collecting client risk preferences and assets, which generate an optimal portfolio asset allocation using secret formulas. Portfolios usually hold Exchange-Traded Funds (ETFs) matched to common indexes: domestic stocks, commodities, and TIPS, among others.
This fintech marvel gained tremendous popularity by focusing on four qualities:
Democratic. Anyone with a few hundred bucks could now invest.
Automated. Hands-off, reliable, and accessible to everyone.
Cheap. Bypass the painful account minimums and fee structures of traditional financial advisors.
Access. Unlimited access to tailored financial planning and advice.
Here’s a fast-facts list of what draws investors to the robos.
- Non-existent entry costs. Most services charge little to nothing to open an account.
- Minimums. Customers can get started with as little as $500 ($1 in some cases).
- Low fees. Fees range from 0% per year to 1.0% of Assets Under Management (AUM).
- Low expense ratios. Robo-advisors usually hold ETFs, which have an average expense ratio of .44%, usually much less.
- Online. Robo-advisors are accessible online, through proprietary apps, and they never rest.
The Nuts and Bolts of Robo-Advisors
So what makes a robo-advisor tick? Let’s get underneath the hood to find out just what makes these modern marvels go.
- Indexing. Most robos are built on the foundations of Modern Portfolio Theory (MPT), which in a nutshell, stipulates that holding a balanced basket of stocks, like the Dow Jones Industrial Average, is less risky than active investing.
- Passive (and sometimes active) investing. Trades are limited to reduce fees and commissions.
- Rebalancing. Algorithms decide on an optimal portfolio balance based on a customer’s risk and re-balance automatically to keep the portfolio on-track.
- ETFs. Exchange-traded funds that match an index (think Vanguard) are a common tool to create a proper and balanced portfolio.
- Tech-driven. Complicated mathematically rules ensure that very little costly human intervention goes into trading.
Who Leads the Robo-Advisor Pack
At the time of writing, five companies dominate the robo-advisor market, which consists of over 100 firms. These are listed by AUM, highest to lowest.
Note: the top two are not ‘pure’ robos, as they spun off robo-advisor arms early in the robo-advisor explosion. Betterment continues to be the king of the pure robo-advisors at the time of this writing.
- The Vanguard Group
- Charles Schwab Corporation
- Personal Capital
Robos: Threat or Opportunity for the Savvy Trader?
Robo-advisors represent a macro-trend in investing that is extremely popular. AUM for our robot caretakers is expected to top $2 trillion by 2020. While there are proponents and detractors of this new force of nature, money will be gained and lost by understanding this new phenomenon.
Here are a few trends that have emerged from the robo-advisor craze.
- Millions of low- to middle- income investors are piling into the market.
- Billions of dollars are following the tenants of MPT (rebel traders be ready!).
- ETFs and index-tracked funds have surged in popularity.
- Passive investing and automatic rebalancing means millions of investors are on auto-pilot.
- More and more newbies are discovering trading by first starting with the easy-to-use robos.
Learn From the Machines
If you are convinced robo-advisors will continue to shape the market for years to come, go take a look. Choose the robo that works best for you, sign up, and give it a spin. You’ll come away with a better understanding of the platform, the potential, and the perils.
Good luck traders.
Courtney Bower is originally from the midwest. He travels extensively, writing about today’s big ideas.