The benefits are undeniable
Anyone who has latched onto the Financial Independence (FI) movement has probably discovered that a core tenet of scaling net worth is predicated on minimizing investment fees. The clearest and obvious way of doing so is to simply invest in an index fund that tracks either the total U.S. stock market, the total global stock market, or a large and representative subset, like the S&P 500. Maybe add a total bond market index fund to hedge volatility, particularly as you get closer to withdrawing from your portfolio.
Without going into too much detail into the benefits of index funds themselves (since there are tons of resources on that), the idea of their tremendous value stems from these funds being highly reliable for long-term growth, having low risk of sustained downside during a market downturn, and having minuscule operating expenses of roughly .03-.05%, and don’t require the aid of a financial advisor charging an additional 1% or more which can erode hundreds of thousands of dollars in returns over a few decades.
All the benefits above are legitimate and proven. Robo-advisors, however, don’t contradict the concepts of index fund investing, the goals of the FI community, or even the investment simplicity touted by Bogleheads around the world. Rather, they double down on those concepts and execute them more effectively at a cost that pays for itself. Here are some key things to note when evaluating if a robo-advisor is worth a try.
A closer look at the benefits
Low cost vs high fee advisor
While a high fee advisor is one of the first things the FI community will find deplorable, and rightfully so as stock-picking typically yields worse returns for a far steeper cost, the fees are generally 4–5x higher than that of a robo-advisor. Betterment, for example, charges .25% for its base service.
Perhaps even more important is what that fee is actually paying for. While traditional advisors charge their fees for the expertise to beat the market, robos (at least with their base packages) aren’t even trying to. Instead, their fees pay for optimizing index fund portfolios for tax efficiency, risk profiles, and opportune rebalancing, with a level of precision that only an automation platform can provide. But if they charge a fee, doesn’t that negate the upside? Not really…
Fees are usually the silent killer of returns, but some fees are fine as long as they pay for themselves
To say that all investment fees are bad is like saying that paying for anything is bad. Fees in investing are just like the prices you pay for anything else. If the value derived from what you pay for exceeds the amount you paid for it, then it’s money well spent.
The narrative that most investment fees are bad stems from the fact that most investment fees don’t meet the value criteria above. Robos typically do return higher value than they charge because they enhance the principles of investing for FI (index funds, tax efficiency, rebalancing, dollar-cost averaging, etc.) with technology and automation, rather than contradict these principals like many (but certainly not all) financial advisors in the industry.
Advisors usually don’t beat the market, but robos aren’t trying to (and that’s a good thing)
Roughly 85% of financial advisors don’t beat the performance of the aggregate stock market, and the 15% who do are not the same 15% each year, so picking a financial advisor who consistently beats the market is nearly impossible.
Robo-advisors by contrast simply track funds indexing the aggregate economy or specific parts of it in the most efficient ways possible. “In the most efficient ways possible” is the qualifier that distinguishes robos from manually buying index funds. The additional value this provides may not be huge, but again it goes back to whether that marginal value exceeds the cost, and it’s increasingly difficult to argue that it doesn’t.
Automating (and encouraging) dollar-cost averaging
Just as picking stocks is a loser’s game, timing the market is also a dicey proposition. At the time of this writing, there has been a constant fear of a recession, causing some investors to sell stocks or refrain from buying as many stocks as they otherwise would have. In 2019, the total US stock market generated about a 28% return, leaving the fearful on the sidelines for about as high of a single year gain as one could hope for.
A recession is coming because it’s always coming — but nobody knows when or to what magnitude. This is why dollar-cost averaging, or consistently buying similar quantities of assets at regular intervals, is widely encouraged in the personal finance space.
Just as asset diversification spreads risk by your investment holdings, dollar cost averaging spreads risk by time.
While dollar-cost averaging is possible through any brokerage, not just robos, it is encouraged and easily discoverable in the user interfaces of most robo-advisors. This helps the novice investor who may not understand the benefits of dollar-cost averaging to take part in it and minimize risk while also benefitting from market upswings whenever they come.
Buy low and sell high, by design
Warren Buffet has a popular saying that you should buy when others are fearful and sell when others are greedy, yet the average investor does the complete opposite. Adhering to Buffet’s principle is BUILT INTO the product with robo-advisors. This is because rebalancing with robo-advisors is based on maintaining your risk profile and asset allocation, not based on arbitrary time periods.
As an example, suppose you have a target stock/bond ratio of 80/20. There may be a market downturn in stocks (which usually but not always has an inverse relationship on bonds) resulting in your allocation changing to 75/25. Automated rebalancing will detect this change and sell your bonds to buy stocks, reverting back to your 80/20 split. This means you were effectively able to buy additional stocks at a discount without having to lift a finger.
By contrast, suppose you do not use a robo-advisor and instead rebalance manually at the start of each quarter. If the same market downturn happens midway through the quarter, but eventually regains value back to its original level by the start of the next quarter, you will have nothing to rebalance. This misses out on the opportunity that presented itself during the market downturn.
To the naked eye, it may seem like nothing happened in the latter scenario, but robo-advisors are built to act on these opportunities precisely when they occur, every time that they occur, at a completely reasonable fee. Frequent rebalancing is often chided due to trading costs, but since robos bake this cost into their fees, the cadence of rebalancing should not be of any concern to the robo investor.
Tax efficiencies in asset allocation, harvesting, and withdrawals
Robo-advisors build automated tax efficiency into their services so that you don’t have to be a tax professional to optimize taxes tied to your investments. Taxes in a broader sense can still be complicated enough that an individual may be warranted in consulting a tax advisor based on their individual situation, but tedious tax optimization techniques are fully automated in typical robo-advisors. This includes, but may not be limited to, the following:
- Tax coordinated portfolios: If you hold both a taxable account and a retirement account (like a traditional or Roth IRA) with a platform like Betterment, your portfolio will place high income-yielding assets, like various types of bond funds, into your retirement accounts to shield that income from taxes while maintaining your overall target asset allocation.
- Tax-loss harvesting: Tax-loss harvesting allows you to sell assets at a loss, simply for the sake of incurring the loss, to apply that loss to reducing your taxable income or offsetting gains. Robo-advisors that offer this feature then buy a substantially similar asset to keep your risk profile and asset allocation effectively unchanged. Betterment published content on the added value of tax-loss harvesting over time, in excess of fees. Of course, it is a self-serving piece which markets their own product, but the analysis is worth looking into for anyone skeptical of the value of tax-loss harvesting.
- Tax-efficient withdrawals: Eventually, you will withdraw funds from your portfolio to live off in your post-working years, or for any major expense like a down payment on a house. Deciding which assets to sell, in which quantities, can be a complicated decision that many people get wrong and incur unnecessary taxes as a result. Betterment, on withdrawals of any size, withdraw funds in the following order, exhausting each bucket before moving to the next in the sequence:
- short-term losses
- long-term losses
- long-term gains
- short-term gains
This sequence ensures the lowest tax liability on a withdrawal, automatically, as short-term losses can be applied against taxable income or gains, and on the other end of the spectrum, short-term gains are taxed as ordinary income, which has the least favorable tax implications.
ETFs instead of mutual funds
While index funds track the performance of broad asset classes, there is a small difference between whether these indexes are in an Exchange Traded Fund (ETF) or a mutual fund. Ultimately, if they are index funds the cost should be quite low either way, however, ETFs are designed for fluid trading. Popular index funds will often have each type representing the same index. For example, Vanguard’s index funds tracking the total US stock market are represented by an ETF with ticker symbol VTI, as well as a mutual fund with ticker symbol VTSAX.
While supporters of indexed mutual funds may suggest that they minimize trades and therefore minimize sales costs (which is fair), robo-advisors leverage ETFs, which are designed to change hands with greater regularity, to have the fluidity to shift things around and offer the benefits mentioned previously. The associated cost of this trading, however, is baked into the robo advisory fee so the investor doesn’t pay any additional cost for this subtle difference while still benefitting from the value that the robo platform provides.
People who don’t use robos and manage a simple set of index funds themselves may prefer to use mutual funds rather than ETFs to minimize costs, understandably, but for robos to offer the benefits they provide, it typically requires them to use ETFs. The difference, however, is extremely minimal, so there shouldn’t be any concern or overthinking this when evaluating the decision to use a robo-advisor.
Goal management, tracking and performance reporting
One of the most common recommendations for people early in their FI journey is to track their expenses, income, investment returns, and ultimately net worth, over time. Just getting into the process of being more aware of your finances rewires your brain to feel more in control.
Robo-advisors have put A LOT of time and resources into their interfaces, reporting visualization, and user-friendliness. This includes having different accounts for different goals, such a short-term goal like a major purchase, which will likely have a conservative portfolio or a long-term goal like retirement having a more aggressive portfolio.
Lack of awareness of one’s own finances is one of the biggest obstructions to financial literacy, and robos make it easier than ever to rid individual investors of the idea that money management is too complicated for them to take ownership of.
A ringing endorsement
Arguably the most influential and widely known voice in the FI community, Mr. Money Mustache, set out a well-documented experiment with Betterment to evaluate the pros and cons. He’s become a strong supporter of the company and the tech in spite of various concerns along the way and has moved much of his net worth under Betterment’s management. Having a close look at his analysis and decision process is a great read for anyone not yet convinced.
Risks to keep an eye out for
Beware of ancillary offerings that stray from the core value of robo-advisors
Wealthfront and Betterment have introduced offerings which give more toggles and controls to the investor to modify portfolio allocations to their liking OR have advanced portfolios that attempt to exceed aggregate market returns. Smart Beta from Wealthfront aims to increase returns through smarter portfolio weightings, while Flexible Portfolios from Betterment aims to give users more control if they want it. This to me is where robos lose much of their value.
If beating the market is extremely difficult, and usually only accomplished by a select few who spend endless hours analyzing financials and probably getting lucky, then accomplishing this either through use of advanced technology or by handing the keys to the average investor is something to take extreme precaution with. Additionally, the base portfolio makeup of robo-advisors is already fueled by machine learning and millions of data points. While I’d lean more toward trying a product like Wealthfront’s Smart Beta than Betterment’s Flexible Portfolios, for now, I plan on ignoring both services and just trusting that algorithms can handle the basics of passive investing to yield results as good or better than any premium add-on over time.
The non-robo robo
While Betterment’s base package charges a .25% fee, they also offer a .40% fee offering that includes access to a human advisor. As I have never used that service myself, I won’t say that it’s good or bad, but simply will note that leveraging a fee for “advice” is counter to many of the principles that generate wealth unless the value provided exceeds the cost consistently over time. While I don’t plan on leveraging this any time soon, it’s up to the individual investor to determine the value of such an offering.
Beware of the wash-sale
The wash-sale rule is a tax stipulation from the IRS that prevents you from offsetting losses against your income due to selling assets when identical or nearly identical assets are then purchased within 30 days. This is to prevent investment transactions that are conducted solely for lowering taxable income rather than to reflect the inherent value of the asset itself.
While the tax-loss harvesting feature of robo-advisors is designed not to violate the wash-sale rule, that is only true for the assets MANAGED BY the robo. The wash-sale rule applies to ALL your investments, so if you sell an asset automatically through the robo, and then buy a substantially similar asset the next day through a different brokerage, you may violate the wash-sale rule. This even applies to reinvested dividends.
The way I’ve gotten around this is to not hold substantially similar assets to what’s in my robo portfolio in any funds outside of my robo. As I use Betterment for the vast majority of my investing, they do not hold an index fund tracking the S&P 500 (at the time of this writing) in their portfolios; instead, they only have total stock market index funds as the closest comparison. Therefore, for my few investments that are outside Betterment, (employer 401k, HSA, spouse’s 401k, etc.), I invest only in S&P 500 index funds. This minimizes the chance for violating the wash-sale rule ACROSS accounts.
Fees will stay low due to the market share land grab
I initially had some reluctance to put more and more of my assets into Betterment as I was consolidating in order to reduce wash-sale risk. My concern was based on the fact that if I had all my assets with one single source that charged an advisory fee, they could raise that fee and I would be backed into a corner since I would not want to sell assets and pay taxes in order to transfer those assets elsewhere. In fact, Betterment actually did change their pricing once before, changing to a flat .25% from a tiered pricing model where the lowest price tier was .15%. Anyone in that lowest price tier had to simply absorb the price increase or move their investments to another source and likely incur taxes.
There are a couple of reasons why in spite of that price change I don’t really have any concern of additional pricing increases:
- Firstly, the initial price change was driven by simplification, not supply and demand
- Secondly, Betterment (or any other robo-advisor) can’t afford to raise prices in their efforts to gain market share.
As popular as robos have become in recent years, they still have an extremely low share of assets under management relative to the entire market. As robos inevitably gain more of this market share collectively, especially with millennials having more invested assets over time, the battle will be in WHICH robos capture this trend.
Born robos like Betterment and Wealthfront will compete with robo spin-off offerings from more established institutions like Schwab and Vanguard. If anyone of them raises prices, their ability to capture market share will be severely inhibited due to the competition (unless the price increase is accompanied buy a clear and obvious value to the customer that far exceeds its cost, which is also a win).
The jury is still out in the personal finance community
Are the fees worth it?
Given the relatively new popularity of robo-advisors, there are still mixed opinions in the Personal Finance community as to whether the fees are worth it. A couple of highly credible and influential voices offer differing takes on the matter:
JL Collins, author of The Simple Path to Wealth, acknowledged initial reluctance and skepticism around robos, but looked deeper and notes that they may be a worthy complement to further financial independence efforts for many in the future.
Ramit Sethi, author of I Will Teach You to Be Rich, offers less of an endorsement, suggesting that while the concepts of robos are sound, he doesn’t know that they actually provide value in excess of simply buying low cost index funds through a no fee brokerage and occasionally rebalancing. Sethi also suggests that these platforms over-market the true value of things like tax loss harvesting as things that really move the needle.
Sethi brings up good points, but I generally believe that tax loss harvesting IN ADDITION to tax coordinated portfolios and automatic rebalancing based on asset allocation drift (rather than based on arbitrary time intervals) collectively justify the cost. Even if the margin in which the value exceeds the fee is debatable, if you believe the value exceeds the fee at all (and does so consistently), then using a robo is definitely worth consideration.
An easy way for young people to take ownership and limit idle cash at an early age
Perhaps one of the greatest macro-level benefits of robo-advisors is that they encourage younger people to invest early and plant the seeds for compounding to work in their favor. In my 20s, like many 20-somethings, I avoided investing just due to lack of understanding and a notion that it was way more complicated than it really is. This led to periods of sitting on idle cash in a bank account losing value to inflation, as well as a period of holding most of my assets with a high fee brokerage.
Getting started early is so much more important than getting every detail perfect, and robos go a long way in getting young workers more comfortable and confident with investing so they can one day stop trading their time for money and live on their own terms.
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