Investing

DR 136: 5 Reasons Robo Advisors are Worth the Cost

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As robo advisers grow in assets under management, more people are beginning to ask if using one is the right strategy. My last podcast on robo-advisors brought this email from a reader named Steve:

“The other timely podcast was the robo-advisor one. I’m in the process of helping my mom move her accounts from Morgan Stanley over to Vanguard where I’ll be managing them for her. Meanwhile, my IRA and taxable accounts are all at Betterment. It’s always in the back of my mind whether I should be paying the 15 basis points or moving my money to Vanguard. The end of your podcast reassured me a little. I’ll be really interested to hear your follow-up podcast. Betterment just makes it so dang easy to automate my deposits into my taxable accounts. I feel like I’m getting more value for the taxable accounts and less for my IRA accounts. The reason being that my IRA is static. I’m not adding to it. It seems like it would be simple enough for me to balance it myself once or twice a year. On the other hand, my taxable investments I automatically invest into every time I get paid. Betterment is able to balance them easily with the new money.”

The biggest issue with robo advisors is cost. Sure, their fees are lower than what you would pay for traditional investment management services. But any fee is significant given the multiplying effects over decades of investing.

For example, an annual robo adviser cost of .25% will reduce an 8% annual rate of return to 7.75%. While that may not make much difference in any single year, it can have a major impact over a period of ten, twenty, or thirty years of investing.

Here is a sampling of the costs of a few automated investment advisors:

Obviously, the higher the costs, the greater the impact will be on future investment returns.

But that’s not the whole story on robo adviser costs - not by a long shot. While these services add costs on top of the fees charged by the underlying ETFs, they also provide automated tools that make up for these costs (and in some cases even exceed the costs).

Podcast of the Article:

My Epiphany on Robo Adviser Costs

The more research I do on robo advisers, the more I am becoming convinced that cost is not the negative I initially thought it to be.

Whenever we look at costs for anything, we always need to balance it against the benefits that we’re receiving in exchange for those fees. My position is now that the cost associated with robo advisers is actually reasonable.

There are five reasons for my change of thinking on this front

1. The Cost is Reasonable Compared to the Alternatives

As described above, the costs associated with using a robo advisor do reduce future return on investment. While the costs are reasonable, in my opinion, we shouldn't be dismissive of them. Let's look at some examples.

We'll assume an 8% return before robo advisor fees, and a 7.75% return after the fees are taken out. Over the course of just one year, the results seem insignificant. A $100,000 investment, for example, would be worth $108,000 a year later at an 8% return (I'm ignoring taxes for now). With an automated service charging 25 basis points, the return drops to $107,750. A fee of $250 to let somebody else deal with asset allocation and rebalancing seems like a small price to pay.

But what happens if we multiply this “small” fee over 40 years of investing? The numbers get really big. If you do the math, you find that an annual cost of .25% reduces your nest egg over an investment lifetime by enough to buy a home.

For example, if you invest $1,500 per month in a 401(k) (that’s $18,000 per year, which is the 401(k) maximum contribution beginning in 2015) at a rate of 8% per year, you’ll have something approaching $5.2 million after 40 years. But if you reduce your return to 7.75%, after removing the cost of a robo adviser, you’ll end up with something just over $4.8 million.

Thus, while 25 basis points may not seem like a lot, it can add up to about $364,000 over a lifetime of investing.

Now it may sound like I'm arguing against these investing services. I'm not. Rather, we just need to dispel any notion that a "small" investment fee doesn't matter. All investing fees matter.

With that said, there are two reasons why this fee is reasonable. First, while the difference may add up to $364,000 over 40 years, in today's dollars it's much smaller--roughly $50,000. That's still a lot of money, which brings me to the second reason.

Robo advisors offer technology that can increase our returns. Through automated rebalancing and tax loss harvesting in taxable accounts, services like Betterment and WealthFront can offset these costs. In some cases, they may even produce excess returns that exceed their fees.

Related: Best Robo Investors

2. Rebalancing

Even for a seasoned DIY investor, rebalancing can be an arduous task. I’ve been doing this for more than 20 years and still find rebalancing to be a pain in the neck. You can see my approach to rebalancing in Podcast 338 and Podcast 52. Because it can be such a hassle, many investors fail to rebalance their portfolios for extended periods of time.

With computers, however, robo advisers can rebalance your investments more quickly and easily than you can. And because of that, they can do it much more frequently. These services use a trigger-based rebalancing approach, which results in rebalancing when an asset class strays from the plan by a set percentage.

At a minimum, rebalancing ensures that the risk level of a portfolio remains the same. Beyond risk, there’s evidence indicating that regular rebalancing improves investment returns. An analysis by Yale University Chief Investment Officer, David Swenson, concluded that rebalancing earns an average of .40% more each year, over 10 years, than portfolios that are not rebalanced.

If that’s the case, then the benefits of automatic rebalancing that robo advisors provide may more than offset an average cost of .25% for using the service.

3. Tax Loss Harvesting

Like rebalancing, tax-loss harvesting (TLH) is something that is much better accomplished by computers than it is by individual investors. It’s a strategy in which losing investments are sold in order to create tax losses to offset taxable gains elsewhere.

Should your capital losses exceed your realized capital gains, you can use up to $3,000 of the excess loss to reduce non-investment income. Any losses in excess of $3,000 can be carried forward into future years.

TLH will have no benefit with retirement accounts, since they are tax-deferred. But since TLH at the core is a tax deferral strategy, it can effectively give the benefit of tax deferral to taxable accounts (by enabling you to defer taxes on capital gains almost continuously).

And again, like rebalancing, TLH may produce an increased return on investment. The calculations are complicated, but here are some links that describe the process, as well as the increase in return from TLH indicated by each source:

Though the increase in annual return from TLH varies widely depending upon the source, it’s clear that there is some measurable increase. When an increase in return is combined with the increase in return from rebalancing, it most definitely appears that the tangible improvement in return more than offsets the costs of using robo advisor services.

4. Account Level Asset Allocation

For the person who doesn’t want to be hands-on with his or her investments, the asset allocation provided by robo advisers can be a godsend. And even if you don’t mind creating and managing your own asset allocation strategy, life is just easier when someone else takes care of it for you.

All of this is especially important if you have multiple investment accounts. While creating and maintaining an effective asset allocation can be fairly simple in a single investment account, it becomes geometrically more difficult as the number of accounts that you have increases.

As an example, I currently need to increase my exposure to commodities. I own a commodity ETF (ticker: DBC) in my SEP IRA (yes, I know it should be in a taxable account; that's a discussion for another article!). The problem is that I don't have the funds in my SEP IRA to buy more of the commodities ETF. As a result, I'm forced to buy it in a different account if I want to maintain my planned asset allocation. That presents a host of other problems, including (1) lack of a good commodities fund in my 401k, and (2) selling investments with unrealized gains in my taxable accounts to buy shares of DBC. Robo Advisors element this problem.

5. Convenience

Finally, it is impossible to overlook the convenience factor as a benefit associated with robo advisers. Since investment activity in a robo adviser account is virtually automatic, you will have that much more time for your non-investment life.

Bonus Reason: Easy Socially Responsible Investing

What if your investments could change the world? Well, it won’t happen overnight but, over time, socially responsible investing (SRI) could make a big impact. The purpose of SRI is to invest in companies that support clean energy, healthy living, and social equality. Companies are chosen based on their emphasis on the United Nations’ 17 Sustainable Development Goals.

An easy way to jump on board the SRI train is with Betterment. For as little as $50 you can begin your investment journey with a robo advisor with a strong socially responsible investing focus. Learn more about Betterment here.

Next Steps

I am still exploring Vanguard’s Advisor Service. For 30 basis points, Vanguard will manage your investments for you. I suspect, however, that I’ll end up moving a significant portion of my assets to Betterment. and WealthFront. I plan to use Betterment for my retirement accounts because it has the lowest fees (15 basis points for accounts over $100,000) and use Wealthfront for my taxable accounts because of its excellent TLH tools.


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