What is a Robo-advisor?

Toni Nasr, CFA, FRM

A Robo-advisor is an online wealth management service that helps users automate their investment process with little or no human intervention. It learns a bit about your investment profile by asking you a series of questions about your financial situation, investment objectives, and how you see risk. Then, it offers you a suggested portfolio strategy that best suits your preferences and works to invest your funds based on this strategy automatically.

Learn how a Robo-advisor works, what services are offered, and whether or not this sort of automated investment is good for you.

How do Robo-advisors work?

Robo-advisors work similarly to human financial advisors. They will ask you some questions to learn more about you, and then they will suggest a specific diversified portfolio that they believe matches your profile and is suitable for you. The main difference is that its portfolio management services are automated.

Robo-advisors have the same types of questions. You might be asked to answer questions regarding:

  • Your financial situation: how much money you earn, how much savings you have, and whether you have any debt;
  • Your investment horizon and goals: whether you are investing for retirement, buying a house, or short-term savings;
  • Your risk tolerance: whether you are okay with seeing your investment fall in value over time before showing gains and whether you are willing to take risks to increase your potential future return.

Then, the Robo-advisor uses your answers as inputs to a smart computer algorithm to offer you a portfolio of investments best suited to your profile. Those portfolios consist of a combination of investment securities that fit specific profiles and might include one or a combination of the following asset classes:

  • Equities, where you will be directly holding shares of a particular publicly listed company like Tesla, Microsoft, or Amazon;
  • Fixed income securities, a type of debt instrument providing returns in the form of regular interest payments like corporate bonds, government bonds, or emerging market bonds;
  • Alternative investments, which include hedge funds, private equity investments, or cryptocurrencies;
  • Real estate: purchasing a property to generate income from recurring rentals or an appreciation in value. Robo-advisors use Real Estate Investment Trusts (REITs) which are companies that own income-producing properties across different sectors;
  • Commodities, where you will be investing in precious metals like gold and silver, energy resources like oil and gas, or agricultural commodities like wheat and coffee.

The majority of Robo-advisors tend to invest in equities and bonds. They work on spreading your investment among different asset classes, which is a process called diversification. It can reduce the volatility of your portfolio since not all asset classes move in the same direction and can also enhance your risk-adjusted returns. So it helps balance the risk of the overall portfolio and assists in protecting your wealth.

To have a diversified portfolio, Robo-advisors give you exposure to a pool of asset classes by using one or a combination of the below instruments:

  • Exchange-Traded Funds (ETFs), where you will be buying an instrument representing a basket of securities combined into a pooled investment used to track a specific index or sector. Most Robo-advisors use only ETFs to build their portfolios;
  • Actively managed mutual funds, which are financial vehicles managed by professional portfolio managers (like Vanguard or BlackRock), manage the funds actively daily, based on a stated investment objective, and sometimes holdings might be restricted to specific sectors or geographic areas;
  • Index funds, which represent a specific segment of the market and are designed to match the performance of the market and are usually passively managed.

Services offered by typical Robo-advisors

Automatic risk profiling of clients and portfolio recommendations

As we described earlier, Robo-advisors know your profile by the answers you give when answering their in-house questionnaires. This inquiry is the primary source of data used to recommend an appropriate portfolio to new investors.

Automatic rebalancing

Once the client's portfolio is constructed, rebalancing is executed periodically, where the weights of each asset class are returned to their target allocation weight percentages. Usually, those percentages are stated in the factsheet of a strategy or clearly stated on the company's website.

Personal advisor access and portfolio customization

Some Robo-advisors provide access to financial advisors. These services may be offered to large portfolios after reaching a certain amount or just to help new clients with investment planning. Although certain Robo-advisors do not offer access to a personal financial advisor, they have a customer support team who might help you better understand the investing process and answer your inquiries.

Tax Efficiency

Robo-advisors might provide tax-efficient services, where they work on maximizing what you will get after accounting for taxes rather than just maximizing profits in general. They might use tax-loss harvesting techniques, a strategy that involves the sale of securities at a loss to offset a realized capital gain and, consequently, help increase the tax efficiency of your investments. For example, if an ETF loses value significantly, it will be sold automatically to lock in a capital loss, and simultaneously, it will buy another ETF having the same exposure. The algorithms of Robo-advisors allow tax-loss harvesting to be performed automatically.

Other services might include offering access to tax-efficient accounts like ISAs for UK residents (where you will be exempted from paying tax for a certain amount) or IRA accounts in the US.

How do Robo-advisors make money?

The primary revenue stream of Robo-advisors is through a fee charged as a percentage of assets under management (AUM), known as a “management fee,” or even a fixed monthly fee. Usually, the percentage ranges from 0.25% to 1.00%, depending on the company and the amount invested. Many companies offer tier pricing, which means different percentages for different bracket amounts.

Robo-advisor companies may also earn money on commissions from deposits, withdrawals, and transfers (they usually state it clearly on their website). Additionally, companies might use cross-selling strategies to further monetize their user base. For example, if the Robo-advisor is part of a bank, you might end up opening an account with the bank. Or they can enter into strategic partnerships where they market targeted financial products to their users.

Another way of generating money is by earning interest on the cash balances allocated to each client’s account. This can be a significant source of income if the company has a high number of users.

Pros and cons of Robo-advisors

Pros of Robo-advisors

  • Simple and easy to use: The apps and websites are usually user-friendly and very easy to navigate, making managing investments an easy task;
  • Low cost: Robo-advisor fees are relatively low (under 1%) compared to having a personal financial advisor who charges between 1% and 2%.
  • Low minimum amount to start investing: Many Robo-advisors have low minimum deposit requirements, whereas some financial advisors require a very high minimum deposit to start managing your funds;
  • Automated investing: investment recommendations and portfolio rebalancing are automated;
  • Fully regulated: the entities offering Robo-advisor services are regulated, meaning that your money is protected up to a certain amount (depending on jurisdictions) through an Investor Protection Scheme. (Be aware that this protection is related to the company's risk and not in case your investment loses).

Cons of Robo-advisors

  • Limited investment selection: Most Robo-advisors use a predefined list of ETFs to build their portfolios, and clients are not able to change the selected ETFs;
  • Limited type of ETFs used: Some Robo-advisors use distributing ETFs (not accumulating ETFs), which may be tax-inefficient in some jurisdictions;
  • Not totally personalized: Robo-advisors do not provide a personalized plan that considers all aspects of your financial situation;
  • Lack of discretionary decisions: Robo-advisors build their strategies based on algorithms, whereas human, financial advisors can make subjective decisions based on their expertise;
  • Restricted asset classes: The majority of Robo-advisors invest only in equities and fixed income, so you do not have exposure to alternative investments, real estate, or commodities.
Tada Images / Shutterstock.com

Are robo-advisors right for you?

Before checking which Robo-advisor is best for you, you should determine if Robo-advisory services are right for you first.

Investors who have limited capital, are looking for long-term investment opportunities, do not want to be constantly monitoring their portfolio, and are comfortable that funds are managed based on an automated strategy with no, or minimal human intervention would find that Robo-advisors are the best choice for them.

Alternatively, the greater the amount of money you have, the more you will need a more personalized plan to manage your funds. So, you might need more personal assistance tailored to your specific situation and objectives.

What features should you check while choosing a robo-advisor?

There are lots of Robo-advisors out there. We list below some of the main features that we think you should be checking while deciding which Robo-advisor is best for you.

  • Minimum balance requirement: some companies do not have a minimum balance requirement to open an account, but you have to reach a pre-specified higher amount to start investing;
  • Fee structure: examine the fee structure for assets under management, deposits, and withdrawals;
  • Socially investing strategies: you need to check the strategies and portfolios available in case you want to invest in socially responsible strategies (investing in companies that have a positive impact on society and the environment);
  • Access to a personal financial advisor if you feel more comfortable speaking with someone;
  • Account opening process: check if you can open an account easily online;
  • Country availability: some Robo-advisors are available in limited countries. In some cases, if you need to move to another country, you might be obliged to close your account;
  • Services offered: automatic rebalancing or tax-loss harvesting are provided by different Robo-advisors and could be helpful.

Bottom line

Robo-advisory services can be a convenient investment option for many investors. Robo-advisors' automated investment portfolios offer a low-cost investment option for investors who may not be able to invest with traditional wealth management firms.

Robo-advisors cannot replace personal financial advisors who provide tailored investment plans for investors. However, specific tasks such as selecting the best-diversified securities that fit the risk profile, automatic rebalancing, and tax loss harvesting can be automated for new investors.

Curious to explore our reviews of Robo-advisors available on the market? You can check our review page for an unbiased opinion on several Robo-advisors.

Other FAQs on Robo-advisors

Can you lose money if you invest through a Robo-advisor?

Although Robo-advisors provide a diversified strategy and work to minimize risks, you are still at risk of losing money. Keep in mind that, in general, no investment can guarantee positive results.

Can I beat the market with a Robo-advisor?

No, Robo-advisors' goal is not to beat the market. They usually invest in ETFs and give you exposure to the broad market or a specific sector and work on closely matching the performance of their benchmark.

What is the minimum amount to start investing with a Robo-advisor?

Some Robo-advisor companies have no minimum amount. You can start with as little as $1.

You can check our list of Robo-advisors available with their minimum deposit requirement.

Related Articles