What is a robo-advisor?
When the words robo-advisor first entered the investing lexicon, it referred to a company that offered a robo-advisor tool and the platform itself. With many traditional financial institutions providing robo options today, the term refers to the technology involved.
Essentially, a robo-advisor is a cloud-based technology platform that, in many cases, invests on behalf of a user.
There are other ways to invest online, of course. For example, with discount brokerages, you put money into an account and then you have to divvy up those funds among securities on your own.
Robo-advisors, on the other hand, automatically split up the assets in your robo account (again it could be an RRSP, RESP, TFSA or others) into various exchange-traded funds (ETFs) based on your risk tolerance and goals. An ETF is a basket of securities that’s similar to a mutual fund but isn’t actively managed; often, it’s set up to track a specific market index, such as the S&P 500 Index. ETFs are also different from mutual funds in that they can be traded on the market, like an individual stock or bond.
It’s this ease of use that’s made robo-advisors so popular. Most work in a similar way: You fill out a questionnaire to determine your tolerance levels, you then connect your bank account to the software and enter the amount you want to invest. The robo-advisor will then put your money into its funds and continually rebalance your dollars to keep your asset mix where it should be.
Should I use a robo-advisor?
The short answer for many people is yes. Now that robo-advisors are catering to people up and down the wealth spectrum, everyone should consider using one. Study after study has shown that high fees can significantly eat into long-term returns and these sites come with lower than average expenses.
In general, robos are passively managed, meaning there isn’t usually a human who makes active decisions about buying and selling specific securities within the portfolio; so if you want to invest in more actively managed portfolios, or prefer do-it-yourself stock picking, may want to look elsewhere, though some hands-on investors are now incorporating robos into their personal repertoires.
Robo-advisor versus human advisor
In some ways, the term robo-advisor is misleading; they are, for the most part, companies that have found a way to simplify the investing process. They don’t provide in-depth financial advice and they don’t care about your big life events that might affect how and how much you should invest. Human advisors, on the other hand, can both invest funds on your behalf and help you figure out a personalized financial plan.
However, more companies are offering some hybrid of robo and human advice where the software does the investing and the human provides the financial advice. We’ll likely see more of that in the future, as it appears to be what people want: A Capital One survey found that 69% of investors would like to use a digital-human hybrid to manage their money, while 74% say they want a financial advisor to help them get through turbulent markets.
Robo advisors vs. mutual funds
A lot of people tend to compare robo-advisors to mutual funds, but that’s not quite accurate. A robo-advisor is a technology platform, while a mutual fund is an investment product. What people are really comparing when they talk about robo-advisors versus mutual funds is ETFs versus mutual funds, because the vast majority of robo-advisors build client portfolios with ETFs.
It’s highly likely that there would be no robo-advisors without ETFs, at least in their current form. Why? Because it’s really easy to create a portfolio with passive funds. Since ETFs are priced and traded during the day and on normal stock exchanges—rather than being priced once a day at market close—robos can quickly move people in and out of these investments. That makes automatic rebalancing, a key robo-advisor feature, simple to do. As well, because ETFs are not actively managed like mutual funds, they’re a lot less expensive to own. That can make using a robo a more affordable alternative to a human advisor.
ETFs, like mutual funds, are diversified baskets of stocks or bonds. However, while mutual funds are actively managed with an aim to beating the market (spoiler alert: they often don’t), ETFs passively track the market. A S&P/TSX Composite Index-tracking ETF will hold all the funds in the index. Put a few of these together into one portfolio—a Canadian, U.S., European, an emerging market and a bond fund—and you’ll set yourself up for the long term. You could create a similar portfolio with actively managed mutual funds, but it’s better to use ETFs. Decades of research has shown that ETFs consistently outperform actively managed funds—in large part because mutual fund fees, which, in Canada, average about 2%, take too much of a bite of total returns. Many big-time investors, including Warren Buffett, advocate for ETFs.
Robo-advisor technology was built to quickly create an ETF portfolio based on an investor’s risk tolerance level and time horizon. Most robos use a predetermined number of ETFs (they’re not mining the entire ETF universe) that can fit into most people’s portfolios, and then they split up how much of each ETF a person should own based on a risk tolerance questionnaire. A conservative investor would have, say, more money in a bond ETF than an aggressive one. The ETF structure makes it easier to automate this process than if they used mutual funds.
In the future, all sorts of securities could end up in a robo-advisor portfolio, but for now ETFs trump mutual funds.
Pros and cons
- Charge low, flat fees
- Use easily liquid and easily tradable ETFs
- Creates a diversified portfolio based on one’s risk tolerance and time horizon
- Automatic rebalancing
- Automatically allocates money to various ETFs
- Investors can’t always change asset mix on their own
- Typically uses only ETFs; investors may want to add other securities into their portfolio
- Uses specific ETFs; investors may prefer different brands that the robo doesn’t utilize
- Redeeming isn’t always instant like it may be with a discount brokerage
- Diversified basket of stocks
- Funds are managed by a professional, which many people still prefer
- A lot of different fund options on the market
- Some funds have track records that go back decades
- Generally high fees
- Can only buy and sell at the end of the day
- Not as tax-efficient as ETFs
- Aren’t usually available through robo-advisors