Editors' pick: Originally published April 1.
Can a computer pick stocks for you better than a human financial advisor? That’s the simmering question in the rise of robo-advisors.
Of course, computers are beating us at lots of things, from chess to a wildly popular board game called Go (where Google’s AlphaGo has obliterated human champs).
Literally hundreds of robo-advisor companies have sprouted to do battle. Many are start-ups. Some grow out of established financial services companies (such as Schwab Intelligent Portfolios).
Expect sustained growth. Management consulting firm A.T. Kearney, in a recent report on the sector, forecast that robo-advisors will manage $2 trillion in assets in the U.S. by 2020.
Should you be plunking down your cash on the computer?
A more foundational question: why now are robo-advisor firms taking off? Jon Stein, CEO of Betterment, a New York based robo firm that recently closed a $100 million funding round, said that it’s become easier to build “significant computing platforms.” He pointed to open source software and cloud-based services that have let robo-advisor firms scale on the fly, without costly front-end investments.
The other factor in the rise of robo firms: a lot of investors suffered real losses in the 2008 to 2010 stock market meltdown, said Stein. “The reps of many big [traditional] firms were tarnished," said Stein. "There was a loss of trust in traditional financial services providers.” Those investors turned their back on traditional firms and, when they want to get in on the Wall Street action, many are looking favorably on robos.
Here is how robo-advisors work - and all work roughly the same way, said multiple sources, although each home brews its particular algorithm. An investor is asked various questions designed to gauge his risk tolerance. Once risk is determined, the computer hunts for investments that align with the person.
A plus: robo firms impose fees well below the 1% of assets that is a typical charge at traditional brokerages. Betterment, for instance, charges 0.15% on a $100,000 account. That’s $13 per month versus $83 per month at a traditional firm that charges 1%.
But there's a key difference between robo-advisors: some - like Fidelity’s - recommend the company’s own investment vehicles, and others, like Betterment, which calls itself the largest independent automated investment service, do not have funds of their own to recommend. Does that matter? Stein believes so. “We offer unconflicted advice," he says. "We recommend the best assets for you, without regard to our own interests. We don’t recommend our own funds.”
Different experts see it differently and, in point of fact, many traditional investment firms have long recommended their own products. So this may not be a deal killer but it is a difference to be aware of.
Millennials seem particularly enthused about robo-advisors, said Timothy Baker, founder of WealthShape, an investment advisory firm. He nonetheless has closely studied robo-advisors and, he said, Millennials are attracted to the ease of use - essentially a robo-advisor service is just another computer program to them.
Many robo firms also are scrambling to offer advice - at extra cost - to investors who find themselves with questions the machines cannot answer.
Traditional firms also are rushing to offer robo services to investors who prefer that style. “The future for most robo firms will be inside large institutions,” said Boaz Lahovitsky, senior vice president of wealth management at Genpact, a business process transformation company.
Are robo firms for everybody? Even Stein thinks not. He said: “When you have more than $2 million in investable assets you are a target for financial advisers.”
Most robo firms also build portfolios around ETFs, exchange-traded funds, that track an index or basket of assets. That can be ideal for some investors. Others may want more flexibility in building a portfolio.
Baker, however, predicted that robo-advisors will “pick up a lot of smaller accounts.”
Baker also said what the real test of robo firms will be: “The next bear market. How will they survive?” His point: the stock market has been in a six year bull run. Lots of investment advice has worked because lots of investments are prospering. How good will robo-advisors look when the market cratered as it did in 2008? “Their test will be a true bear market,” Baker said.
This article is commentary by an independent contributor. At the time of publication, the author held TK positions in the stocks mentioned.