When are Robo Advisors an Effective Option for Investors?

The Benefits and Drawbacks of Utilizing a Robo Advisor for Your Wealth Management Strategy

Choosing a financial advisor is an important and often difficult decision. Certain situations call for certain solutions; however, in today’s financial landscape there are more options than ever, including robo advisors. We dug into the robo advisor trend to explore the benefits and drawbacks of this investment option.

What Are Robo Advisors and Where Are They Offered?

Robo advisors are online portfolio management tools that allocate client capital to a diversified mix of exchange traded funds (ETFs). ETFs are typically low cost index tracking vehicles that trade throughout the day on exchanges, much like a stock. Some ETFs invest in stocks, some invest in bonds, and others hold alternative assets such as commodities or real estate. Robo advisors determine the right mix of stocks, bonds–and, in some cases, alternatives–for their clients’ portfolios based on their risk tolerance and time horizon, which is often determined by an initial survey conducted when opening an account.

There are several robo advisors in the market today. Betterment and Wealthfront are two of the leaders, with others such as WiseBanyan and Personal Capital also growing their assets under management. Fidelity and Schwab, well-known as low-cost online brokerages, have also recently begun offering robo advisor solutions.

While robo advisors are a relatively new solution to wealth management, the conceptual framework has existed for decades. Vanguard and other fund families have offered balanced mutual funds, which provide a similarly diversified mix of stocks and bonds, with varying levels of risk and expected return to match the preferences of the client.

These solutions can be effective for some investors, particularly young professionals with smaller portfolios, who are looking for a solution that will require less maintenance and allow them to focus on their career rather than managing their investment portfolio. However, there are some drawbacks to this solution as well.

As the Name Implies, Robo Advisors Lack the Human Element

While some robo advisors offer the ability to discuss your portfolio with an actual human, they do not typically have a physical office available for customers to visit or a team of experienced experts that are available to discuss the portfolio. This solution works for some investors, especially during strong bull markets, but it is much more difficult to stay invested and maintain, or add to, your portfolio during difficult markets.

Having a trusted advisor help you through difficult markets can mean the difference between a successful long term outcome and a discouraging experience. When establishing risk profiles for accounts, robo advisors ask questions like “The global stock market is often volatile. If your entire investment portfolio lost 10 percent of its value in a month during a market decline, what would you do?” When establishing an account, it can be tempting to say that you would buy more, as we are all taught to buy low and sell high. In reality, it can be difficult to execute this strategy without the guidance of a trusted advisor.

Robo Advisors Don’t Offer Active Management Strategies

Robo advisors typically invest solely in passive index ETFs, which have the benefit of low costs and performance that is consistently aligned with the overall market. This approach tends to work well for many segments of the market, but it can also mean that investors are missing out on alpha generation opportunities in less efficient markets, such as small cap international equities. At Lake Street, we believe a mix of active and passive strategies results in the optimal risk/return profile for investment portfolios.

A Robo Advisor is Unable to Oversee Your Entire Portfolio

Many investors who use robo advisors also have savings invested in 401(k)s or other employer-sponsored plans. Having an advisor oversee and understand the entire picture can improve returns and reduce risk by ensuring the proper overall diversification and allocation.

You Don’t Get the Benefit of Financial Planning Services

Having an advisor that can oversee your investment portfolio, tax situation, and estate plan can add significant value. When all components of a family’s financial picture are managed in a coordinated manner, investors benefit from a cohesive strategy. Using a robo advisor for your wealth management doesn’t provide that type of holistic financial planning.

A Robo Advisor Won’t Take Advantage of Additional Asset Classes

While some robo advisors offer alternative asset exposure through commodities and real estate, there are no options to include potentially higher-returning asset classes such as private equity and venture capital. While not available to all investors due to portfolio size and liquidity constraints, these asset classes have historically outperformed traditional asset classes (as measured by Cambridge Associates US Private Equity Index against S&P 500, MSCI AC World, Bloomberg Barclays Aggregate Bond Index, Wilshire REIT, Bloomberg Commodity Index and HFRI Equity Hedge over the 20 year period ending 12/31/2016) and can add a meaningful benefit to a portfolio.

Robo advisors are an easy-to-use and low-cost tool that are a great solution for many investors. However, there are limitations and drawbacks that should be considered before choosing to use a robo advisor rather than a team of trusted experts.