UAE: Robot financial advisors on rise: Is it worth the cost? How does it fare against traditional alternatives?
Cost analysis of different alternatives to know which of these options are cost-effective
Dubai: As an investor, you have always had two options when it comes to managing your investments. You could do it yourself through something like an online broker or you can work with a financial advisor.
With the entry of robo-advisors, online investment services that offer financial advice driven by algorithms, there’s a third option, and that’s to merge the benefits of professional money management and advice with the convenience of an all-digital application.
Since launching more than a decade ago, robo-advisors have grown into an industry that managed $460 billion (Dh1.7 trillion) in 2020 – a 30 per cent increase from 2019. Some analysts predict robo-advising will become a $1.2 trillion (Dh4.41 trillion) industry by 2024.
They are essentially a class of financial adviser that provide financial advice or investment management online with moderate to minimal human intervention. They provide digital financial advice based on mathematical rules or algorithms.
In other words. robo-advisors are automated portfolio managers and can often be thought as an autopilot for investors. Robo-advisors manage your assets based on your goals and your tolerance for risk.
Since portfolio management is handled by software rather than a human financial advisor, robo-advisors charge lower fees, which can translate to higher long-term returns for investors.
Who are robo-advisors meant for?
Most robo-advisors manage both individual retirement accounts and has minimum investment requirements. Although some robo-advisors require $5,000 (Dh18,366) or more, a majority have account minimums of $500 (Dh1,836) or less.
Are robo-advisors cheaper?
While traditional (human) financial advisors typically charge 1 per cent or more per year of your total investments, most robo-advisors charge around just 0.25 per cent per year.
They are able to charge lower fees because they use algorithms to automate trades and indexed strategies that utilise commission-free and low-cost ETFs.
On top of that, you’ll pay a fee to the robo-investor for doing the work for you. They will choose your funds and rebalance them as necessary. Now let’s look at what this could actually cost you in the long run.
Are robo-advisors worth the cost? How it fare against other options?
To give you a sense of the way these different fees add up over the years, here’s an analysis. Here are the assumptions:
• You’re saving Dh5,500 per year in a retirement fund (or about Dh458 per month).
• You get an average annual return of 5 per cent.
• You’re 25 years old. This gives you about 40 years until retirement age.
With regard to fees, 0.25 per cent of your investments are assumed as the fee for a robo-advisor, as that’s the median fee across the board. To estimate the cost of a financial advisor, an estimate of 2 per cent of total managed asset value is used.
While we compare the fees associated with making use of robo-advisors in managing your investments, versus human financial advisors, let’s also compare them to what it would cost when using other alternatives. Before that let’s briefly look at what these alternatives are.
An exchange-traded fund is a type of investment fund and exchange-traded product, i.e. they are traded on stock exchanges.
ETFs are similar in many ways to mutual funds, except that ETFs are bought and sold throughout the day on stock exchanges while mutual funds are bought and sold based on their price at day's end.
An index fund is an investment that tracks a market index, typically made up of stocks or bonds. Index funds typically invest in all the components that are included in the index they track, and they have fund managers whose job it is to make sure that the index fund performs the same as the index does.
A target date fund – also known as a age-based fund – is a collective investment scheme, often a mutual fund or a collective trust fund, designed to provide a simple investment solution through a portfolio whose asset allocation mix becomes more conservative or less risky as the target date approaches.
A type of index fund is a target-date fund, which aims for your planned date of retirement, shifting investments as you get older. This would be a very simple way for you to “set it and forget it” when investing for retirement. Pick a date that you’ll expect to retire, and put all your money in that fund.
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Comparing costs of an Index Fund, Target Fund to having a Robo-Advisor
When comparing the cost of a mutual fund or ETF, you need to look at the expense ratio (which are the operating costs relative to your investment amount). The expense ratio is the percentage fee the fund charges to pay for its management.
Actively managed funds (ones that have a person running it) are the most costly. Index funds are passively managed and cost much less.
Cost of target-date funds and ETFs
According to US-based brokerage Morningstar, the average expense ratio of target date funds is around 0.78 per cent. So for every Dh100,000 you have invested in the fund, you’ll pay Dh780 in fees.
But that’s the average target-date fund. A US-based Vanguard target-date fund could cost as little as 0.14 per cent, which is almost 82 per cent off.
As ETFs are traded on the like stocks, they are more versatile and liquid than a mutual fund, making it much cheaper.
Example: Cost comparison using four different investment methods
The amount you could pay in fees over the course of 40 years for a financial advisor is over Dh260,000. If you assume the same return and the same contributions for each option, then the one that costs the least will also be the cheapest over the long term.
However, target-date funds, robo-advisors, and financial advisors all claim to offer consumers a better deal: higher returns, less hassle, or both.
Financial advisors, especially, claim that they can beat the market and get much higher returns. However, research shows that 90 per cent of them miss their targets.
How have robo-advisor portfolios performed against target-date funds?
While it’s impossible to say what return a hypothetical financial advisor would give you over the long term, we can however, say what target-date funds would have given you over the past five years.
If you select 90 per cent stocks (which a 25-year-old should), and set your range from between June of 2011 and June of 2016, then the average annual return for your portfolio would be about 5.6 per cent.
Perks of using a robo-advisor
• Robo-advisors offer you convenience and peace of mind
Robo-advisors take the work and worry out of the three most important elements of retirement planning: regular contributions, low fees, and a diversified portfolio.
• Robo-advisors keep you diversified automatically
You want to separate your investments, keeping a certain amount in stocks (and different kinds of stocks), a certain amount in bonds, and possibly some even in cash.
However, due to shifts in the market (i.e. stocks go up or down, or bonds go up or down), those amounts may get out of balance, and far away from where they should be to reduce risk. When that happens, you need to rebalance.
Robo-advisors’ algorithms automatically rebalance your portfolio based on a number of different factors, like your age and the amount of time you have until you need the money.
• Robo-advisors put your money in low-cost ETFs
Robo-advisors mostly invests your money in exchange-traded funds, which tend to be very cheap, with expense-ratios often under 0.10 per cent.
Verdict: Robo-advisors or traditional (human) advisors?
Consider all types of costs when you are deciding how to invest—specifically the financial and time costs or savings of signing up with a robo-advisor.
If you’re new to investing, experts suggest you try it on your own and check out robo-advising. But if you’re a savvy investor and have time to dedicate to in-depth research and frequent monitoring of your portfolio, a robo-advisor may not be for you.
Will robo-advisers ever completely replace human advisors?
Robo-advisors are becoming mainstream, which is good news for consumers who are looking for low-cost financial advice. Time is on the side of the robo-advisory industry as the technology continues to improve and the younger generations accrue more wealth.
Research has shown that interest and support from millennials and Gen Z helped robo-advisors rise to prominence. While critics have remained skeptical about whether robo-advisors can entirely replace human advisors, many robo-advisors are providing hybrid services that combine human and digital advice.