by Jack Waymire
The robo advisor revolution, which started off with such promise, seems to have lost momentum. These automated digital-advisory services attracted a sizable amount of investor assets initially, but growth has slowed recently as the limitations of robo advisors, also known as robos, have become apparent. It now seems clear that the claims that they would take over the investment world and put financial advisors out of business were unfounded.
Now that the initial hype over robos has died down, what role will these digital advisors play in the investment world going forward? Will they fade away altogether or is there a niche they can fill? Are low fees their only real advantage or do they offer services that investors can’t get elsewhere? What are their strengths and weaknesses? In this article, we’ll define robo and take a look at the top 8 questions investors ask about robo advisors.
What are robo advisor strengths and weaknesses?
The following strengths have been attributed to robo advisors:
- Algorithm-based investing. Robos enable investors to invest at least a portion of their portfolio in a managed account that uses an algorithm based on a systematic investing approach such as Modern Portfolio Theory (MPT) to allocate and rebalance assets. MPT looks at the historical performance of asset classes with the goal of devising a current portfolio based on this data that provides the highest potential upside at the lowest possible risk.
- The ability to invest in a completely digital, online process without the need to speak with a human advisor. While many investors prefer to speak with and meet their financial advisor, for the small subset of investors who don’t have an interest in doing so, a robo can be a convenient option.
- Automatic rebalancing. If your portfolio becomes unbalanced in relation to your investment objectives and risk tolerance, it can be automatically rebalanced.
- Low fees. Because they rely completely, or almost completely, on online interaction, these digital advisory services can offer very low fees, typically ranging from 0.1 to 0.4 percent. Some robos will charge higher fees to investors who want the ability to talk to a human advisor at times.
The following are weaknesses of robo advisors:
- The lack of personalized advice. While these services can offer portfolio building recommendations based on your stated investment objectives and risk tolerance, this is not the same as having access to a financial advisor who can provide you with advice on a regular basis regarding your personal financial situation.
- Rebalancing inflexibility. While most robo advisory services offer a portfolio rebalancing feature that brings your account back into balance with your investment objectives if it diverges from your recommended asset allocation parameters, they typically don’t rebalance due to changes in market conditions. Thus, they can’t offer the same flexibility as a human investment advisor, who can offer advice tailored to current market conditions rather than simply relying on past historical data for portfolio management purposes. Thus, when modern market performance diverges from historical patterns, a robo advisor doesn’t have the flexibility that a human advisor possesses to update portfolio allocation recommendations accordingly.
- No or limited human contact. While this feature helps robos keep their costs low, it runs contrary to the traditional reason investors hire a financial advisor – to have access to a financial expert they can consult with about their investments.
- Limited financial planning functionality. While robos can offer automated investment advice on the basis of their MPT-aligned algorithms, offering full-fledged financial planning advice is simply too expensive for these services. This type of advice, which takes into account an investor’s cash flow, short and long-term financial goals, tax status and more, is best offered by human financial advisors.
Why are the brand-name robos the big winners?
While the early movers in the robo advisor sector, such as Betterment and Wealthfront, have captured substantial market share, their portion of the robo advisor pie has been eroding in favor of robo advisory services offered by pre-existing investment firms such as Fidelity, Vanguard and Charles Schwab. Because robo advisors don’t provide much in the way of human interaction, it only makes sense that investors who want to use this type of service have been drawn to the big names in the direct-to-investor category of the financial services industry.
Given that robos charge low fees as part of their business plan, raising the funds to market their services to compete with the major brokerage firms that have expanded their services into the robo advisory sector is difficult to do without raising fees. However, if they do decide to raise their fees for this purpose, they do so at the risk of losing market share.
Who do robos appeal to?
Robo advisors initially made headway with early adopters attracted to the idea of getting advice digitally, without the need to speak with a human advisor. They have also had early success with investors with small amounts to invest who don’t meet the account minimums of human advisors. While most investors prefer to be able to speak to their investment advisors on demand, a subset of investors who don’t require or can’t afford such contact has been drawn to robo advisors. However, with growth slowing, it is not clear that robo advisors can change their business model to attract a broader group of investors than the narrow demographic that accounted for much of their original growth.
Is pricing the primary advantage of robos?
With the recent introduction of portfolio management software that enables an advisor to build a portfolio according to MPT or other similar investment theories and provide reallocation services like those offered by a robo advisor, pricing remains the main advantage these services offer. However, as advisor pricing models have evolved to reflect competition from robos, this may be less of an advantage moving forward.
Still, for the time being, investors who prefer to use an investment advisory service where they don’t speak with an advisor at all, or very rarely, can benefit from the low fees charged by robos, which continue to serve as their primary advantage when compared to many – but not all – financial advisors.
Are robos the best solution for investors with smaller asset amounts?
As investment advisors have adopted business models enabling them to offer robo advisor-like services at lower price points, investors with smaller asset amounts can get the best of both worlds by working with human investment advisors. This gives investors the chance to speak with an advisor who knows them personally while still receiving lower fees. An exception to this would be stockbrokers or investment salespeople who sell investment products with high commissions. In these cases, an investor could still benefit from the lower fees charged by a robo advisor.
Are investors with larger asset amounts comfortable with no face-to-face contact?
Face-to-face contact is usually an essential component of an investment relationship for this type of investor. This reflects the reality that the investment planning process becomes more complex as investment amounts increase. Tax considerations, estate planning and other such issues associated with investing require more consultations and in-person meetings to plan a strategy to deal with such issues. This factor may explain why robo advisor growth has slowed substantially recently. After snagging assets from early adopters, the limited appeal of such services to those with significant assets to invest appears to be restricting their ability to grow their Assets Under Management (AUM).
Can robos solve the communications gap without adding more people, which will cause their fees to go up?
As robo advisors attempt to improve their ability to communicate with investors, they start to look more and more like traditional direct-to-consumer brokerage firm advisory service offerings, which offer managed account services with access to a team of advisors on the phone or in person. If they attempt to avoid this model by trying to offer more access to advisory personnel without adding staff, they risk alienating their clients by heavily restricting when they can speak with an advisor. However, if they add more personnel to solve this problem, they will have to raise fees as a result, losing their status as true robo advisors.
Will new technologies that can be used by the average advisor leapfrog the tech advantages of the robos?
The core advantage offered by robo advisors has been low-cost investment management using respected investment concepts to allocate investor funds. However, this advantage has been countered to a large extent, as human advisors have increasingly adopted software that enables them to perform the same or similar functions as robos. In a sense, robos have helped human advisors evolve their practices to provide both on-demand access to their clients in the form of phone calls and meetings and access to the latest portfolio management technology and practices. As advisors have updated their business models to leap ahead of robo advisors in the services they offer and the prices they charge, it’s not clear how these digital advisory services can compete other than as a narrow niche product.
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