What is a Robo-Advisor? - Robinhood (2024)

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A robo-advisor is like a self-driving car...

A self-driving car has features that allow it to partially or fully take over the task of driving. Driving is a complex process, full of potential pitfalls. Depending on the type of journey, owners of self-driving cars opt to drive themselves — or let the car take over. Likewise, a robo-advisor gives you financial and investing advice for you to make decisions — or complete financial transactions for you.

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A robo-advisor is software that uses a set of predetermined rules (an algorithm) to provide financial advice and even complete transactions. Robo-advisors are a web-based service with an online portal and can sometimes be used with a smartphone app. This technology is an example of fintech — a term used to refer to the meeting of finance and technology or financial technology for short.

By leveraging technology and reducing human interaction, a robo-advisor provides financial and investment management services at lower fees than a traditional financial advisor. Most robo-advisors promote a passive(index-based) investment approach, focusing on minimizing transaction fees. Typically, robo advisors use low-cost mutual funds and exchange-traded funds (ETFs).

Historically, the first robo-advisors focused on investment management. Today, some robo-advisors include additional services, such as cash management (supervising and performing cash inflows and outflows) and retirement planning (setting up retirement goals and acting on those goals). Examples of robo-advisors are Betterment, Blooom, E* Trade, Fidelity, SoFi, Vanguard, Wealthfront, and Wealthsimple.

Robo-advisors provide financial advice to users, so they must be registered investment advisors with the Securities and Exchange Commission (SEC). The SEC is the regulatory body of security markets and brokerages in the United States. As registered investment advisors, robo-advisors are fiduciaries — entities that have a legal requirement to act in the best interest of their clients, specifically a fiduciary standard.

A robo-advisor starts by collecting regulatory required information, such as an individual’s name, social security number, and mailing address. Like any other registered investment advisor, a robo-advisor needs to submit filings to the Internal Revenue Service (IRS) and issue the appropriate tax forms (e.g., 1099-MISC, 1099-DIV, 1099-INT), as needed.

Typically, the robo-advisor proceeds to ask a series of questions about the investor’s income, risk capacity, and risk tolerance.

The set of questions depends on the type of financial services and financial products being offered by the robo-advisor.

The robo-advisor analyzes your answers using its algorithm (a set of established rules based on the company’s investment strategy) to make investment management recommendations and provide financial advice.

A passive investment strategy is the foundation for a robo-advisor’s financial advice and recommendations. Passive investment is the belief that there’s no point in fundamental analysis or stock-picking — instead, you should choose low-cost index funds (e.g., the or Russell 3000) in an attempt to duplicate their performance and risk characteristics.

Based on your questionnaire, a robo-advisor presents you with an investment portfolio consisting of low-cost index mutual funds and/or exchange-traded funds (ETFs). Once you have selected your investment portfolio, a robo-advisor may operate fully-automated or provide you additional assistance through a human financial advisor.

A fully automated robo-advisor operates on its own, seeking to minimize transaction fees and reducing labor costs. Services from a fully automated robo-adviser often include direct deposit, tax-loss harvesting, periodic rebalancing, and dividend reinvestment.

• Direct deposit is the automatic funding of your investment account from a checking or savings account.
• Tax-loss harvesting is the strategic use of investment losses to help offset realized capital gains helping individuals to manage their tax liabilities.
• Periodic rebalancing is the periodic sale and purchase of securities to keep your investment portfolio’s target asset allocations (e.g., 80% in stocks and 20% in bonds).
• Dividend reinvestment is the automatic use of dividends to increase your holdings in a target portfolio.

In addition to the services from a fully automated robo-advisor (e.g., tax-loss harvesting, periodic rebalancing), an advisor-assisted robo-advisor offers you access to a human financial advisor. Typically, the appointments are over the phone or through a teleconference tool. Like the robo-advisor, the financial advisor is a registered investment advisor or a certified financial planner (CFP).

The human advisor can help you with your portfolio and offer additional financial advice. The frequency of access to the human advisor varies across robo-advisor service providers.

Typically, the cost of a robo-advisor (management fee) ranges from 0% to 0.50% of the account balance. Some robo-advisors charge a flat management fee from $0 to $360 per year.

The cost of a robo-advisor depends on several factors, including account minimum, available promotional offer, and type of service.

Some robo-advisors don’t charge a fee as long as you maintain an account minimum — often ranging from $500 to $5,000. Other robo-advisors don’t charge a fee regardless of the account balance. Some robo-advisors charge the same management fee to all accounts.

Additionally, a robo-advisor may have tiers of account minimum fees that unlock additional services. For example, a robo-advisor may upgrade from a fully-automated robo-advisor to a human-assisted advisor upon reaching a specified account minimum.

Promotional offers vary from robo-advisor to robo-advisor. An example of a promotional offer may be a waiver of the management fee for the first year of service.

Another example of a promotional offer is a reduced or waived management fee up to a limit (typically ranging from $5,000 to $10,000).

The concept of a robo-advisor may appear new, but financial advisors have had access to automated tools for portfolio management for several years. Prior to 2008, human financial advisors were the only ones with access to the financial technology behind robo-advisors.

Getting a robo-advisor can be beneficial for beginner investors and those who are just starting to save for their retirement. The low-cost of robo-advisors can be a good first step in receiving financial advice, especially when you haven’t built up the necessary account minimum or can’t afford the fees of a human financial advisor.

As your financial situation and set of investment goals change over time, you may outgrow standardized financial advice from a robo-advisor. As you reach important life milestones (e.g., marriage, birth of a first child, purchase of a home), you may revisit whether or not a robo-advisor is still a good fit.

One of the main pros of using a robo-advisor is low-cost for financial advice. The management fee from robo-advisors ranges from 0% to 0.50% of assets under management. In comparison, the average fee of a human financial advisor is typically over 1% of assets under management.

Choosing low-cost index funds and exchange-traded funds (ETFs) is another way that robo-advisors reduce investment fees. Following a passive investment approach, robo-advisors recommend investments with low expense ratios — a measure of the overall cost of an investment.

For example, an expense ratio of 0.05% means that you pay $5 for every $1,000 in investments. All things being equal when choosing two similar investments, a robo-advisor would favor the investment with the lower expense ratio.

Another pro of using a robo-advisor is the potential automation of several operations. An example of automated activities is the automatic rebalancing (also referred to as periodic rebalancing) of a portfolio to meet target allocations. Another example of automated operations is tax-loss harvesting — the strategic selection of investment losses to offset capital gains and reduce applicable taxes.

By automating investment transactions, a robo-advisor saves you time and allows you to focus on other activities.

One of the main cons of using a robo-advisor is its one-size-fits-all approach to financial advice. A robo-advisor follows a set of predetermined rules (an algorithm) to analyze your responses to an investment questionnaire. If the survey doesn’t include a question that best describes your unique financial situation, then it won’t generate recommendations to address that issue.

Another con from robo-advisors is that your financial situation may outgrow their capabilities. As you get married, buy a home, or have a first child, you may need more complex financial advice. The features of the robo-advisor may not be sufficient at those times, and you would be better off seeking a certified public accountant (CPA), certified financial planner (CFP), registered investment advisor, or financial adviser.

The best robo-advisors are the ones that best fit your unique financial situation and desired service level. Your investment objectives should guide you as to what features the best robo-advisor should have.

Common features from the best robo-advisors are customer service, clear terms of use, filing of form ADV, and transparent fee structure.

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