Robo-advisors are a relatively new breed of online investment advisor that manages your money via computer algorithm. These services select investments (most commonly exchange-traded funds), rebalance your portfolio automatically, and look for tax-loss harvesting opportunities as needed.
Long before robo-advisors appeared, though, there was the target date fund, a mutual fund designed to age along with you. With target funds, an investor chooses a fund that most closely matches the year in which he or she plans to retire. Someone who is currently 27, for instance, might choose a fund with a target date of 2055. That means that the fund will adjust its holdings over the coming decades on what’s called a “glide path,” taking more risk now when the investor is young and less risk as the target year approaches and retirement is imminent.
This rebalancing happens automatically, at least from the view of the investor. But there are often real people involved: Many target date funds are overseen by fund managers. Previously, these funds were knocked for having very little room to change the glide path in response to market conditions; these days, more and more funds are giving managers leeway to make those tactical adjustments, within certain limits.
Target date funds may very well be the biggest competition for robo-advisors (aside from, of course, real live investment advisors). Robo-advisors say they have a leg up for a multitude of reasons, one of which — to quote Betterment, one of the frontrunners among online advisors — is that “retirement age is still the only way a target date glide path is determined, and specific financial circumstances are not factored into their investing advice.” Robo-advisors, on the other hand, tend to take their clients through a short survey that asks not only their age but also their income, current savings, risk tolerance and goals. (You can learn more about how robo-advisors work in our guide.)
Which option is best for you? Let’s compare.
If you’re primarily investing in a 401(k), that settles this debate: Most robo-advisors won’t manage your 401(k) — you’ll need to open a separate IRA or taxable account. If your company offers matching dollars on 401(k) contributions, you’ll want to grab those before considering any outside accounts. Nearly all 401(k)s offer target-date funds as an investment option, and it’s likely your best hands-off choice within that type of account.
Once you’ve captured all of those matching dollars, consider making additional investments into an IRA, and that’s when you may want to consider a robo-advisor.
The “expense ratio” of a fund is the annual fee you pay to have money in that fund. A ratio of 0.5%, for example, means you pay 0.5% of your balance in fees each year. Target date funds carry expense ratios that average 0.78%, according to Morningstar research. Keep in mind that this figure is an average. Some funds will come with lower costs (Vanguard’s funds, for instance, average only 0.17%), and others will be higher. Funds that are actively managed will generally have a higher expense ratio; passively managed funds will be less expensive because you’re not paying for a person to pull the levers. Target date funds may also cost money to purchase, though most brokerages won’t charge you for purchasing their own funds, and because these funds are designed to be held until retirement, those costs add very little.
Robo-advisors typically invest in low-cost ETFs with much lower expense ratios, ranging from 0.05% to 0.20% in most cases. But you’ll also pay management fees to a robo-advisor, and those range from 0.15% to 0.35%, depending on the amount you have invested (one robo, Axos Invest, is completely free). Add those up, and you’re looking at around 0.20% to 0.55% annually. Robo-advisors generally do not charge any trade commissions or other fees, though you should always read the fine print.
Target date funds are not all the same, and the investments in each can vary widely. They’re marketed as a hands-off strategy, but investors still need to look under the hood: Two funds targeting the same date can have vastly different asset allocations. For example, an investor who tells Fidelity that he wants to retire in 35 years might be matched with the Fidelity Freedom 2050 fund, which has 90% equity exposure today and will dial that down to 56% by 2050 and 47% five years after that. Vanguard’s 2050 target date fund, also invested 90% in equities today, will dial down to 48% at the target date and 34% five years afterward. Target date funds also differ in whether they rebalance “to” or “through” retirement: A “to” fund will dial back its level of risk earlier than a “through” fund, which is designed to continue taking risk through retirement age and beyond.
One last note in this area: Target date funds are “funds of funds”; in other words, while most mutual funds carry a mix of stocks and bonds, target date funds invest in other mutual funds. Savvy investors who don’t want to be hands-off could invest in a better mix of funds by self-selecting them from a variety of mutual fund families.
Robo-advisors, too, vary in how they invest your money, but the low-cost ETFs most often used will give the investor exposure to most asset classes. They do the rebalancing by computer algorithm, often looking for opportunities daily but making changes when money is deposited, dividends are paid, distributions are taken or market fluctuations cause drift; in other words, when the asset allocation moves out of line by a predetermined percentage. They also look within taxable accounts for opportunities for tax-loss harvesting — taking losses to offset gains and therefore reduce your tax exposure. Robo-advisors have more wiggle room to respond to market conditions.
» Find out why robo-advisor performance is only one piece of the puzzle.
Level of involvement
Phrases like “set it and forget it” are frequently tossed around, but to be clear, you should always have one eye on your money. This is your retirement, after all. That caveat aside, both target date funds and robo-advisors allow you to be pretty hands-off once the bones are in place. Robo-advisors give you the added benefit of knowing that someone — or rather, something, in the form of a computer — is checking in on your investments daily to make sure things are on track. You can probably feel more comfortable giving up the reins to a robo-advisor.
The bottom line
It’s possible that a robo-advisor could pull better returns with a more customized investment portfolio, at lower fees. They certainly claim to do that, with both Betterment and Wealthfront boasting returns over 4% higher than the average U.S. DIY investor. That said, you want to stack your options side by side and see which comes out on top, paying particular attention to your annual costs.
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