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As competition heats up among big banks and fintechs alike, the number of investment options has increased steeply. In the past, it was possible to charge high fees to hire a human advisor to manage your portfolios. There are many options available today, which include robo-advisors.
The problem is that while this can make it easier to choose, it could also lead to decision paralysis. You have too many options to invest in one. Oder two. Perhaps three.
It is possible to hear of all the different investment options. But don’t give up. There are so many choices.
But don’t fret. We’ll be comparing robo-advisors and target-date funds in this article to help you choose which is best for you.
What exactly is a RoboAdvisor?
An investment manager who uses algorithms to handle your investments, called a robo-advisor. The idea behind a robo-advisor is to reduce human involvement as much as possible. While there are some benefits to using this method, the most important is to reduce costs. They may also have advanced features like tax-loss harvesting.
The invention of robot-advisors is relatively recent. In fact, Betterment was the first widely available robo-advisor. Betterment was created in 2008 and launched its robovisor in 2010.
Robo-advisor technology can be used in almost any way you want. Robo-advisors, in essence, are just code that allows you to make investment decisions based on certain parameters. Each company can decide how to use this technology.
Companies offer diverse portfolios of ETFs that include stocks and bonds. ETFs also have low fees, called expense ratios, so this setup keeps the fees low overall. It gives investors wide market access that is easy to manage, which allows them to enjoy stable and strong returns.
Investors may also have the ability to adjust their investment mix according to their time frame and risk tolerance. Betterment offers an option that allows investors to lower their risk in retirement.
Robo-advisors can be used to diversify and maximize returns. Remember that robo-advisors don’t have to be applicable in every situation. As a result, robo-advisors like Betterment and M1 Finance offer specialized portfolios tailored to responsible investing, retirement planning, and even investing in marijuana.
What’s a Target-Date Fund, exactly?
TDFs are either mutual funds or ETFs which aim to provide a balanced return and risk. TDFs have been around longer than robo-advisors, but they are still relatively new; the first one was created in the 1990s.
The fund names will usually include a year at the end. These funds have an end date. You should invest in TDFs that match the year you plan to retire.
This is because it’s rare to find funds that offer separate TDFs each year. They will instead have a set of TDFs that expire every 5-10 years. If you don’t have the option to choose the year you want to retire in, then you can pick one fund close by your desired retirement year.
TDFs have the advantage of being rebalanced as they age to lower your risk. You are less likely to lose value when you approach retirement. You don’t even have to input anything. TDFs are a great option for novice investors looking to start a nest egg.
Management Fees
At the end of the day, management fees are one of the most important considerations when choosing an investment strategy. This isn’t just about nitpicking. A difference of just one percent in management fee can end up costing you thousands over the long-term. We would be negligent if we did not consider the differences in fees between target-date and robo-advisors.
In addition to ETFs and mutual funds, there are fees known as expense ratios. ETFs and mutual funds can also be managed actively, which results in higher expense ratios. When comparing expense ratios with target-date mutual funds and robo advisors, this can often be true. However, this is not always true.
For example, according to Vanguard, the industry average expense ratio for target-date funds is 0.55%, while the average expense ratio for Vanguard TDFs is 0.12%.
Compare that to robo advisors. Robo-advisor fees Often, they are lower than target-date funds’, though not always. Our average expense ratio was 0.09 for robo advisors. However, many robo-advisors charge an additional management fee which brings the average fee to 0.37%.
But there are exceptions. SoFi Invest, for example, does not charge management fees to manage its Automated Investing Portfolios. The expense ratios for its portfolios range from 0.05% to 1.05%.
Both target-date funds and robo advisors have fees that can differ quite significantly. Keep your management fees and expenses ratios below 0.4%.
Account Types
Which type of account you want to open will affect the options you have if you want to use a robo-advisor or invest in a TDF. You may not be allowed to invest in TDFs if your employer has a retirement plan, such as a pension or 401k. However, most robo-advisors will only accept accounts similar to 401k and similar.
One exception is blooom which is a bot-advisor meant to handle employer-sponsored retirement plans. That said, most robo-advisors are geared toward brokerage accounts and individual retirement accounts (IRAs). TDFs can be offered by robo-advisors. M1 Finance is an example.
There is a lot of overlap, as you can see. If you’re not sure which strategy to choose, make sure to take advantage of any matching contributions offered by your employer. Also, consider the tax advantages that retirement accounts offer before you put money into brokerage accounts.
Portfolio Strategy
Target date funds are actively managed, while robo-advisors use an investment algorithm. These two approaches are fundamentally different. But the question remains: How different are they in terms of their investment strategies?
Robo-advisor Strategy
Robo-advisors are different from target-date funds from the start. Robo-advisors require investors to complete a survey asking questions about their income and risk tolerance. It will then suggest the best portfolio for each investor based on the information provided. The allocation can be modified by investors, however it will still optimize based upon your answers.
After you’ve finalized the allocation, the robot-advisor starts to work. They often use Modern Portfolio Theory (MPT), continually monitoring and optimizing portfolios. They ensure that your portfolio has the best allocation possible and use passive indexing strategies.
Robo-advisors employ an algorithm that optimizes your portfolio and ensures it is performing at its peak. All of this is done without the need for human intervention. Betterment, like other robo-advisors, can reduce your risk over the long term, much in the same way as a TDF.
Target-date Fund Strategy
Target-date funds work differently than robo-advisors. TDFs use a roadmap to show where they will be allocated at different points. Instead of using an algorithm that ensures your portfolio matches a target, TDFs reduce your volatility and risk by reducing the time it takes to allocate funds.
TDFs may not be all created equally. The funds invest in various mutual funds to reduce stock market exposure. However, different TDFs may adjust your exposure in a different manner. Two TDFs may have the exact same target date, but they might not be the best.
It’s important to examine a TDF’s investment strategy before you invest in it. Many TDFs have some kind of tool or document that shows how investments evolve over time.
What is right for you?
The decision between robo-advisors and target-date fund is difficult. It can be hard to pick a winner.
It really comes down to personal preference. Do you like the most up-to-date technology for optimizing and monitoring your portfolio’s performance? A robo-advisor might be right for you.
Are you more traditional and would prefer a plan that is planned out in advance, which can be followed over time? A target-date fund might be the right choice.
Bottom line: While there isn’t necessarily a clear winner for everyone, we’re a big fan of robo-advisors. If you want to start creating your own custom portfolio, set up a Betterment account today.
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