This is a guest post from my good friend Larry Ludwig at Investor Junkie. I've known Larry for years — and even worked with him. He's got some solid insights into differentiating between Robo-advisors.
Robo-advisors are a hot topic in the fintech investment world. It seems like a new robo-advisor is popping up every few weeks. Even traditional banks are getting in on the action.
I’ve spent many hours researching and reviewing all of the services out there. The most common question I get for someone wanting to use a robo-advisor is, “How they are different? How does one robo-advisor compare to another?”
Following are the top five features that differentiate the robo-advisors. Use these to help pick the one that is right for you.
The most obvious difference between robo-advisors is their fees. The two most popular robo-advisors are Betterment and Wealthfront; their annual fees are the same at 25 basis points or 0.25% annually.
Editor's note: you can read my Betterment review and decide if that's the right choice for you.
Everyone else is somewhere in between.
Just make sure you are comparing apples-to-apples in the annual fees. Personal Capital, for example, includes trading fees and can assist with your 401(k) plan as well.
None of the services include the fees of the funds used. Always consider this when figuring out your total cost in using said service.
Not all ETFs or mutual funds are created equal; your total annual fee could be over 1% when including the fees of both the robo-advisor and the funds they use. While cheaper than the average 2% a typical human advisor costs, this annual fee can add up in the long run.
2. Minimum Deposit
Robo-advisors, on the whole, are targeting young Millennial investors. To investment professionals, these individuals are in the “accumulation phase” of their investment lifecycle. This means these people might have a decent income, but their net worth is still in the early stages.
Based on this information, you would assume minimum deposit requirements for robo-advisors would be small or none, and you would be right in this assumption.
Many of the robo-advisors we’ve reviewed have a zero minimum deposit, and many of the others require under $10k to start. Some of the outliers, like Vanguard, require over $50,000, but in my opinion, they are targeting an older demographic.
3. Tax Optimization
Some firms offer no options when you have taxable money to invest. In most cases, it's better to avoid using those robo-advisors and use one that can help minimize the taxes you pay. Reducing taxes is particularly important to individuals who are in the higher tax brackets.
There are primarily three ways a robo-advisor can reduce the taxes you pay:
- Tax Deferred Accounts – Offering dedicated retirement accounts that are tax deferred, such as a traditional IRA, is the most obvious way to reduce taxes.
- Tax-Efficient Funds – The funds the robo-advisors select ideally should be different in a taxable account than a tax-deferred account. Funds like muni bonds are tax efficient and can yield a higher return because of no taxes paid. Another method used by some firms is to own stocks directly, which mimics an index but also minimizes the taxes needed to pay annually.
- Tax Loss Harvesting – By selling a security that has experienced a loss in value, you can “harvest” that loss to compensate for gains or income from other securities owned. This decreases the amount of taxes you have to pay annually.
Out of all the services we’ve reviewed on Investor Junkie, Wealthfront has all of these options. From my experience, it is best-suited for taxable accounts.
4. Asset Allocation
You would expect all robo-advisors to give you the same asset allocation if you answered their questions the same, but you would be wrong in this assumption. Just as there are many roads that lead to Rome, the same applies to the best asset allocation to meet your goals.
No two robo-advisors are alike in the recommended asset allocations they give you.
Part of the problem is the way they calculate your risk assessment profile from the way you answer their questions. They have converted risk tolerance, which is actually subjective, into a computer program with specific inputs and outputs.
The other issue is each robo-advisor recommends specific asset classes while in some cases excluding others. For example, Betterment does not include REITs (real estate investment trusts) or commodities in any asset allocation approved by them.
Other firms, such as Charles Schwab, automatically include 6%–30% cash as part of their recommended asset allocation. Long term that can be a huge drag on returns, but it’s also how they make their money with their “free” service.
5. Human Assistance
Last but not least, some of the robo-advisors aren’t 100% automated. They would be considered “tech-assisted” firms, where human advisors do much of the legwork and use technology to help automate the communications, asset allocation, and rebalancing.
Very few robo-advisors are 100% automated only, Wealthfront being the most strict on wanting to offer only automated services. Even competing service Betterment introduced human advisors to supplement their automated services for those who want the hand-holding guidance. Expect the lines between traditional advisors and robo-advisors to further blur in the coming years.
Robo-advisor services are already becoming a commodity, a checkbox as part of the financial service offerings of many firms. Robo-advisor firms and traditional financial advisors will add more features to further differentiate between them.
Today, it's easier than ever to get started investing, even if you don't make a lot of money.
There are many options when choosing a robo-advisors. I touched on only the five most important options when picking which one is best for you. If you were observant, you've noticed I did not cover the topic of expected returns.
The reason why is no one knows which asset allocation is the best for your investment horizon. I wish I had a DeLorean that could go into the future. I would then know which robo-advisor offered the best returns. Unfortunately, no such device exists.
What I recommend instead is focusing on what you can control: the annual fees you pay, taxes and quality of service. The returns from investing is a crapshoot and no one can predict which robo-advisor will be the winner.