What are robo-advisors?
Have you ever come across a term robo-advisor? Have you ever wondering what that is? The first thing that comes to your mind is probably the “robo” bit, but if you’re imagining a human-like, metal creature you cannot be further from the truth. Robo-advisors are digital, financial advising platforms that make investment decisions without or with a minimal human intervention. They make use of algorithms to allocate assets and manage portfolios. After the 2008 financial crisis, lots of people lost trust in the financial sector and were reluctant to pay financial advisors hefty fees. This is when low-cost robo-advisors came to play and started attracting lots of customers. The other factor that drives robo-advisors is that the majority of millennials are comfortable with online tools, so they expect to have a similar experience when it comes to investing.
How do robo-advisors work?
So how exactly those robo-advisors work? Let’s get into the details.
Robo-advisors collect client’s personal information, risk tolerance and investment goals. Based on that, they choose an appropriate portfolio structure. Most robo-advisors make use of Modern Portfolio Theory to allocate money between different types of assets like stocks and bonds maximising returns while minimising risk. Instead of investing money in particular stocks or bonds, robo-advisors prefer to choose exchange-traded funds (ETFs) to diversify their portfolios even further. Majority of robo-advisors make use of tax-loss harvesting to optimise customers’ taxes. The first thing that a tech-savvy person might notice is the fact that robo-advisors are not that clever. They allocate money based on predefined rules and rebalance your portfolio to bring it back to the base level if there is too much money allocated to one type of assets. Let’s look at this example. Let’s assume you are a fairly young investor and a robo-advisor decides to put 90% of your cash into a well-diversified portfolio of stocks and 10% of your cash into government bonds. If the value of your stock allocation rises to let’s say 95% of the value of your total portfolio a robo-advisor rebalances your portfolio by selling some of your shares and buying more bonds to bring the levels back to 90/10. It is as simple as that. It’s not rocket science at all.
Although the most popular robo-advisors work in this way, there is also a small subset of robo-advisors that make use of AI and machine learning to predict what the most profitable investments in the future will be. These types of robo-advisors are way more exciting, but they also carry a substantially higher risk. Of course, it all depends on how big chunk of our portfolio is actively managed by AI, but from my perspective, it looks like those robo-advisors start to resemble more hedge funds than anything else.
Different types of robo-advisors
As we know from the previous chapter, not every single robo-advisor is the same and there are some substantial differences between them. Let’s have a look at some of the common types of robo-advisors:
- Standard robo-advisors – these robo-advisors work just like described in the previous section. They allocate money between stocks and bonds based on predefined rules. They facilitate passive investment strategy.
- AI-driven robo-advisor – this is the new kid on the block. One of the most popular AI-driven robo-advisor is Responsive that rebalances your portfolio automatically as the economy changes.
- Theme based investing – Motif is a good example of a robo-advisor which allows its customers to have a greater control over where their money goes. Investors can choose from different theme based investments in their Impact Portfolio. For example, Sustainable Planet, Fair Labour or Good Corporate Behaviour.
What are the pros and cons of robo-advisors?
Like with everything there are always pros and cons. Let’s start with the pros:
- lower management fees – robo-advisors offer lower management fees when compared to the traditional financial advisors. The reason for that is quite simple. There is a minimal or no human time required to manage your portfolio and you don’t need to pay machines (besides paying for electricity, space, maintenance and developers’ salaries…)
- low barrier to entry – some robo-advisors can look after your portfolio from as low as $1 which is particularly beneficial for millennials who are, as we know, not very keen on saving money.
- automated process – your portfolio is managed online, your balance and chosen investments are visible all the time and you don’t need to waste time meeting your financial advisor.
- lack of human interaction – for some people, especially the older generation, it is a disadvantage.
- managed portfolios are less personalized – most robo-advisors allocate your money based on the personal information and risk tolerance, but they do not treat customers individually like the real financial advisors. This might change with the help of AI.
- lack of active investment – your portfolio is well diversified and passive. There is no space for excitement and some people find it very boring, but as George Soros said: “Good investing is boring”.
What are the biggest robo-advisors?
Globally, there are over 300 robo-advisors looking after people’s money. The US takes the sheer amount of that market with over 200 of them. The biggest robo-advisors in the US are Betterment and Wealthfront. In the UK the market leaders are Nutmeg, Moneyfarm and Wealthify. Also, some bigger players in the investment business started looking into the robo-advisors space and came up with their own solutions or acquired some already existing companies. Robo-advisors industry is expanding rapidly and its asset under management (AUM) is expected to grow to stunning $4.6 trillion by 2022 (prediction by BI Intelligence).
Robo-advisors seem to be a good solution for someone who’s looking for a passive investment strategy and don’t want to necessarily go into the details of their investments. They definitely fill up the gap in the industry. From the technology point of view, it seems like robo-advisors were inevitable and I’m not surprised they are taking more and more of the financial advising business. In the future, we can only expect more solutions like that and hopefully that will be beneficial for the consumers. I’m also expecting a rise of AI-driven robo-advisors which may dominate the wealth management space.