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A robo-advisor can help you automate the process of investing for retirement and other financial goals. The robo-advisor concept is simple, but for new investors the idea of letting a software algorithm choose your investments may seem somewhat unfamiliar. We’ll take a deep dive into the concept and tell you everything you need to know about robo-advisors.
A robo-advisor—also known as a robo, a roboadvisor or a robo-adviser—is a type of brokerage account that automates the process of investing. Most robos charge lower fees than conventional financial advisors because they invest your money in pre-baked portfolios made primarily of specially chosen, low-fee exchange-traded funds (ETFs). Some robo-advisors also offer access to other more customized investment options for advanced investors or those with larger account balances.
You can opt for either taxable brokerage accounts or tax-advantaged registered retirement accounts (RRSPs) with a robo-advisor. Most robos offer multiple types of registered accounts including RRSPs, TFSAs and RESPs—and they’ll help you choose the right account type based on your needs.
Many robo-advisors can help you save for different personal finance goals simultaneously by providing sub-portfolios with different asset allocations—think a growth-oriented allocation for your home down payment goal, and a more income-oriented allocation for your retirement goals. Increasingly, robo-advisors are also offering basic banking services, like cash management accounts and savings accounts.
Like conventional human financial advisors, robo-advisors are regulated by the Investment Industry Regulatory Organization of Canada (IIROC) and all financial advisors, including robo-advisors, must be registered with that organization, meaning they have a fiduciary responsibility to look out for your best interests when it comes to investment choices. Robo-advisors generally insure their accounts via the Canadian Investor Protection Fund (CIPF).
The “robo” in robo-advisor is a nod to the automated features that are at the heart of this type of investing platform. The automation begins as soon as you sign up, and the onboarding process generally begins with a questionnaire that’s designed to help the software that runs a robo-advisor understand your current finances, your financial goals and your risk tolerance.
If you indicated that you’d prefer to save for retirement, for example, the robo-advisor would likely recommend a RRSP, rather than a taxable account, with a portfolio of ETFs balanced for long-term growth. If you answered that you were looking to save for a home down payment, however, the robo might recommend a taxable account with a portfolio of ETFs balanced for short-term growth.
Some robo-advisors allow you to tweak your asset allocation. Continuing the example above, if this feature were available and your new robo-advisor recommended that your retirement portfolio comprise 80% stocks and 20% bonds, you might be allowed to adjust the allocation to 90% stocks and 10% bonds, adding a bit more risk to the mix.
It’s important to understand that a core advantage of robo-advisors is that you generally do not choose the individual securities and ETFs that make up your portfolio. Robo-advisors pre-select low-cost index fund ETFs (and sometimes other investments, like mutual funds). These are mainly broad-market funds that invest in Canadian stocks, international stocks, bonds and real estate investment trusts (REITs). You may also be able to choose themed portfolios, such as a socially-responsible investing portfolio.
Index fund ETFs charge very low fees and offer strong diversification. Historically, lower cost index fund investments have been associated with better investment returns over time than higher-cost, actively managed funds.
Many robo-advisors use Modern Portfolio Theory (MPT) to design their portfolios. MPT aims to optimize portfolios for returns while minimizing risk through diversification. Think of MPT as applying the “don’t put all of your eggs in one basket” mindset to your investment portfolio. By investing in a wide range of asset types, MPT increases the odds that when some of your investments are down, others will be up. This aims to keep your portfolio trending steadily upward, even during volatile times.
In addition to diversification, most robo-advisors provide automatic portfolio rebalancing and, increasingly, tax-loss harvesting. Portfolio rebalancing helps ensure you keep the right balance of investment types to reach your goals as market conditions change, and tax-loss harvesting can help decrease the amount you owe long term on capital gains taxes.
Robo-advisors generally charge annual management fees of 0.25% to 0.50% of your assets under management (AUM), although some charge a fixed monthly subscription fee instead. Low fees compared to traditional financial advisors are considered one of the key advantages of robo-advisors.
Traditional financial advisors typically charge around 1.0% of AUM per year (fees may decrease for clients with larger balances). On an investment balance of $100,000, a 0.25% robo-advisor fee would amount to $250 a year—while a 1.0% fee would equal $1,000 a year.
Like your investment balance, fees compound over time and can cost you a significant portion of your long-term gains: Over 20 years, for example, a 1% advisory fee may cost you almost $30,000 more than a 0.25% fee on a $100,000 starting balance.
A few robo-advisors claim that they charge zero management fees. Read the fine print, and you discover that some robo-advisors require you to keep a percentage of your portfolio in cash (which means they earn interest on that balance, not you) while other robo-advisors services are only free for balances less than $10,000.
In addition to management fees, you’re generally on the hook for fees associated with the products in which your money is invested by the robo-advisor. ETFs may have much lower expense ratios than mutual funds, but you’ll still be paying them, one way or another.
Expense ratios for index fund ETFs average 0.21% but can run as low as 0.02%. That’s equal to $0.21 or $0.2 per $100 you invest a year. You won’t receive a bill for these charges, though. They are generally deducted from funds’ earnings or cash holdings and are automatically deducted from the rate of return.
Many robo-advisors offer similar features. These include:
Robo-advisors aren’t for everyone. If your financial situation is complicated or you want to invest in more than index ETFs or a very limited selection of other securities, it might make more sense to work with a financial advisor. You might choose a conventional financial advisor if you:
Keep in mind, even with a financial advisor, you may need to consult with other types of financial professionals. You may face situations where you could need access to a tax professional or an estate planning attorney. The more complex your finances, the more likely it is that you need an actual dedicated financial advisor or wealth planning team to help you stay on top of things.
A robo-advisor can be a good choice when you’re starting out and just looking for a simple way to begin growing your wealth. However, as your net worth improves and your situation becomes more complex, you might need to consider turning to a human financial advisor to help you navigate your financial future.
Aaron Broverman is the lead editor of Forbes Advisor Canada. He has over a decade of experience writing in the personal finance space for outlets such as Creditcards.com, creditcardGenius.ca, Yahoo Finance Canada, Nerd Wallet Canada and Greedyrates.ca. He lives in Waterloo, Ontario with his wife and son.