Robo-advisors: Functions, assets and vehicles
Robo advisors combine a variety of services and functionalities to make your investment process easy and convenient.
Which functions do robo-advisor offers?
The first step upon joining will be a questionnaire to assess your age, income, wealth, retirement target age, marital/familial status, risk aversion and liquidity needs. The system will then compute and suggest and optimal asset allocation for you.
Many robo-advisors will then request access to your current brokerage accounts and will start trading directly into these accounts. Other robo-advisors will ask you to transfer your savings into their own platform (Vanguard, Betterment). In either case, the robo advisor will now handle your investments going forward:
- They will first calculate and recommend an asset allocation that matches your risk and revenue profile. An allocation could be 60% of your savings in various equity ETFs, 30% in bond ETFs, with the balance in cash or money-market.
- They will periodically re-allocate your investments to your target asset allocation in a process called automatic rebalancing. In this process, the assets, which have performed better than the portfolio are sold in part and the proceeds are reinvested in the least performing assets, so that the overall portfolio matches its optimal allocation again.
- They will optimize the tax efficiency of your overall portfolio by taking advantage of the tax-deferred status of the investment vehicles you are probably using. The robo-advisors will take into account your employer’s matching if there is one. This process will put the assets attracting the most taxes in tax-deferred or tax-free accounts preferably, while the assets attracting the least taxes take space in taxable accounts.
- Most robo-advisors will harvest tax-losses to reduce the tax implications or your investments and trading. In this process, assets which have depreciated are sold to materialize an accounting tax loss, which offset the capital gain of the portfolio. The assets sold cannot be repurchased immediately. Instead, they will be replaced with similar securities temporarily, say a mutual fund instead of an ETF on the same benchmark.
- Some robo-advisors also offer automated deposits, if not also automatic sweep of your bank account into money market funds, whereby any amount above a certain minimum cash amount is automatically invested into your portfolio. A few even offer checking accounts.
- Robo-advisors are software, but they may also offer the human touch of a financial professional to answer your questions, at the cost of a slightly higher fee and/or a minimum asset requirement.
Which instruments do robo-advisor trade?
Robo-advisors construct diversified portfolios by combining assets of various type within different asset classes. The typical funds are ETFs (global, as well as sector- and size-based), mutual funds. Through these ETFs and funds, you gain exposures to various asset classes equities, fixed-income (aggregates, high-yield, muni-bonds, money-market…) or commodities. Some robo-advisors will offer ESG (Environmental, social and governance) as well as SRI (socially responsible investing) options. Some robos will offer real estate through REITS, as well as access to commodities (gold). Some often keep a small share of the assets in cash or liquid money market funds.
Although the universe of instrument will satisfy the lion’s shares of investors’ needs, not all are exposures are possible. Robo-advisors generally do not offer life insurances, derivatives (options), structured products or more complicated assets (see section 5).
In which vehicles will robo-advisor trade?
Most robo-advisors will manage assets through a large arrays of investment vehicles: Taxable accounts (single or joint), traditional / Roth / SEP IRAs, 401(k)s, Trusts, 529 accounts, which suffice most investors.
If the amount of assets are sufficient, some robo-advisors will set-up dedicated funds for you, allowing you to replicate investments instead of buying ETFs. Besides the lower costs of this approach, it will also maximize your tax harvesting or eliminate unwanted sector/individual exposures.