What is a robo-advisor? How it works, how much it costs, and pros and cons

By James Royal, Ph.D., Bankrate.com

Robo-advisors automate the investing process for you, making it simple to invest in a diversified portfolio of assets — and they cost much less than a typical financial advisor. It’s little wonder that many investors have turned to them, and robo-advisors now manage hundreds of billions of dollars.

What a robo–advisor does

A robo-advisor is a digital platform that uses technology to create a portfolio based on your investing needs.

Generally, you’ll fill out a questionnaire that aims to understand your goals and risk tolerance. Based on your responses, the robo-advisor will recommend a portfolio, though usually you’ll have the option to pick a different portfolio if you like.

Then you simply transfer money into the account, and the robo-advisor invests it according to the investment plan that’s been laid out. You can access your account at any time to see the current market value of the account and how it’s invested.

Robo-advisors can:

• Tailor your investments to your goals and risk tolerance (though that tailoring is limited to the investments offered by the robo-advisor).
• Rebalance portfolios so your asset allocation stays on track.
• Automate the process of tax-loss harvesting (in non-retirement accounts).

If you have a long-term goal such as retirement, the robo-advisor will tend to pick aggressive investments such as stock funds, which have a track record of high returns over time. If you have a short-term goal, the robo-advisor would likely select more conservative investments, such as bond funds or even cash.

How much does a robo–advisor cost?

There are a few fees to consider as you shop around for the robo-advisor that’s best for you:

Management fee: Robo-advisors typically charge a management fee as a percentage of the funds you have invested with them. A typical fee is 0.25% or 0.50% per year, or about $25 to $50 per $10,000 invested. That’s a significant difference from the 1% or more often charged by human advisors. Some robo- advisors charge more than others, but they offer higher levels of service, such as access to a human advisor. Some robo-advisors are free.

Investment expense ratios: In addition to the management fee, you’ll usually pay a fee for each investment, too. That’s because robo-advisors typically build investment portfolios using exchange-traded funds (ETFs). ETFs charge an expense ratio, which is a fee paid to the fund company based on how much you have invested in the fund. A typical expense ratio might be 0.05% to 0.35% per year, or $5 to $35 for every $10,000 invested. You pay these fees no matter which robo-advisor you select, but some robos offer funds with lower fees, so check what they’re charging.

Account minimum: Technically, this isn’t a fee but simply the amount of money you must cough up to invest when you open your account. Robo-advisor minimums vary widely — some have $0 account minimums while others require a few thousand dollars.

Robo–advisor pros and cons

Pros

• Simplicity: It’s easy and fast to create a set-it-and-forget-it investment portfolio.
• Value-added features: Robo-advisors stand out for features such as rebalancing and daily tax-loss harvesting.
• Cost: Robo-advisors are cheaper than traditional financial advisors.

Cons

• No access to human advisors: If you have questions, robo-advisors typically don’t offer access to a human advisor or, if they do, they may charge extra for that service.
• Limited investment menu: Unlike an online broker, a robo-advisor will offer only a limited number of investments.

Who should use a robo–advisor?

A robo-advisor can be especially helpful for:

• New investors who want help building and managing their portfolios. Answer a few questions to determine your goals and risk profile, and after that all you have to do is check your portfolio a few times a year.
• Investors who don’t want to pay a human financial advisor’s fees but want a customized portfolio based on their needs.
• Investors who want a “set it and forget it” approach to investing.

How to open a robo–advisor account

It’s easy to open an account with a robo-advisor. Here are the basic steps:

Gather your information

You’ll need some basic personal and financial information such as your Social Security number and bank account details. Once you have this, you can usually open the account in 15 minutes or less.

Decide how much to deposit

With many robo-advisors, you can open an account without depositing any money. That said, if investing is the next step to reach your goals, it makes sense to start investing as soon as possible.

Set your investment plan

The robo-advisor will use a questionnaire to gauge your risk tolerance and time horizon. From there, it will design a portfolio that meets your parameters. The robo-advisor may ask other questions about your financial goals to further tailor your portfolio to your specific needs and situation.

Popular robo–advisors

Robo-advisors have grown a lot in the last decade, and many of the independent players — those that are standalone robo-advisors— are the best known. However, many well-known financial players also offer a robo-advisor in addition to their other offerings, so don’t assume the independent players such as Betterment and Wealthfront are the only game in town.

Betterment

Betterment is one of the larger independent players, and it requires no account minimum for the entry-level account, which charges a management fee of 0.25% a year or $5 a month depending on your balance and recurring deposits. If you’re looking for more access to certified financial planners, you can step up to Betterment Premium for a 0.65% fee, but you’ll need to plunk down at least $100,000 in the account.

Vanguard Digital Advisor

The top robo- advisor by assets under management is Vanguard, which is best known for its lineup of low-cost funds. Vanguard Digital Advisor takes just $100 to start investing, and you’ll pay an all-inclusive fee of about 0.20% for an index-fund portfolio instead of separate management and fund fees. Depending on the portfolio and funds you select, your fee may be 0.25% for an active portfolio.

Wealthfront

Wealthfront requires a $500 account minimum and charges a 0.25% management fee. Wealthfront offers low expense ratios on its ETFs, goal-based planning and no additional account fees.

Schwab Intelligent Portfolios

You might hear “Charles Schwab” and think “discount broker,” but this financial powerhouse also runs the second-largest robo- advisor. While you’ll need more money than other robos to get started — a hefty $5,000 — you won’t pay any management fee. You can also upgrade to the Premium offering, which requires a $25,000 deposit, $300 start-up fee and $30 monthly fee. But you’ll also have unlimited one-on-one access to a certified financial planner.

Other larger financial players such as Merrill and Wells Fargo have entered the robo- advisor field as well.

Bottom line

While you might feel hesitant to trust your money to a computer app, robo- advisors are actually quite sophisticated. In fact, your traditional human advisor is likely using one to create and manage your portfolio anyway. Robo- advisors provide many attractive services for a reasonable cost, and their ease of use makes them particularly appealing to new investors looking to get started.

Maurie Backman contributed to an update of this article.

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