As competition heats up among big banks and fintechs alike, the number of investment options has increased steeply. In the past, people might have paid hefty fees to have a human investment advisor manage their portfolios. Today, there are a number of low-cost options, including robo-advisors.
But here's the thing: while it is a good thing that people have so many options today it can be lead to choice paralysis. In other words, you have so many investment options, it's impossible to choose just one. Or two. Or three.
You might hear about all of these different ways you can invest, do some research, and just give up. Because there are just so many options.
But don't fret. In this post, we're going to look at robo-advisors vs. target-date funds to help you decide which one is better for you.
What is a Robo-Advisor?
A robo-advisor is an investment manager that uses algorithms, rather than humans, to manage your investments. While there can sometimes be human interaction, the idea is to automate the process as much as possible. This approach has a few benefits, but the biggest among them is reducing costs as much as possible. They may also have advanced features like tax-loss harvesting.
Robo-advisors are a relatively new invention. In fact, Betterment was the first widely available robo-advisor. Betterment was founded in 2008 and its robo-advisor launched in 2010.
There is almost an infinite number of ways to apply robo-advisor technology. After all, robo-advisors are nothing more than code that makes investment choices based on certain parameters. How each company offering a robo-advisor chooses to implement this technology is up to them.
Generally speaking, companies offer diversified portfolios of exchange-traded funds consisting of stocks and bonds. ETFs also have low fees, called expense ratios, so this setup keeps the fees low overall. Plus, it gives investors broad market exposure that requires little to no work, allowing them to have stable, strong returns.
In addition, investors might have the option to modify their investment mix based on their risk tolerance and time horizon. These days, Betterment even has an option to let investors reduce their risk over time as they near retirement.
But robo-advisors aren't all about diversification and maximizing returns. Remember, robo-advisors are just an algorithm that can be applied in almost any scenario. 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 is a Target-Date Fund?
Target-date funds (TDFs) are mutual funds or ETFs that aim to balance risk and returns. TDFs have been around longer than robo-advisors, but they are still relatively new; the first one was created in the 1990s.
These funds always have a given end date in mind; this is usually a specific year and is at the end of the fund name. The idea is to invest in a TDF matching approximately the year in which you will retire.
We say approximately here because you usually won't find a fund manager offering separate TDFs for every single year. Instead, they will have a list of TDFs with end dates every five to 10 years. Thus, if there is not a choice for the exact year in which you will retire, you would choose one of the funds close to your retirement year.
The benefit of TDFs is that they are rebalanced over time to reduce your risk. Thus, you have less risk of a loss in value as you inch closer to retirement. All of this is done without needing any input from you. This makes TDFs good for inexperienced investors who simply want to build their nest egg.
At the end of the day, management fees are one of the most important considerations when choosing an investment strategy. And this is not just nit-picking; a difference of one percent in management fees can cost you tens of thousands in the long run. Thus, we'd be remiss if we didn't consider the difference in fees between robo-advisors and target-date funds.
Mutual funds and ETFs come with fees called expense ratios. Mutual funds can be actively managed, which leads to higher expense ratios. In many cases this is true when comparing the expense ratios you pay with target-date funds vs. robo-advisors. That isn't always the case, however.
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%.
How does that compare to robo-advisors? Robo-advisor fees are often lower than those of target-date funds, but again, not always. We found that the average expense ratio for robo-advisors is 0.09%. But robo-advisors often charge a separate management fee, bringing the total fee to 0.37% on average.
There are exceptions, though. For example, SoFi Invest charges no management fees for its Automated Investing portfolios. And its expense ratios average just 0.05%.
As you can see, fees can vary quite a bit for both robo-advisors and target-date funds. Thus, what is most important is to keep your total fees (management and expense ratios) below 0.40%.
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. For example, if you have an employer-sponsored retirement plan such as a 401(k), you may be able to invest in a TDF, but most robo-advisors won't go near 401(k) and similar accounts.
The one exception to this is blooom, which is a robo-advisor that is meant to manage employer-sponsored retirement plans. That said, most robo-advisors are geared toward brokerage accounts and individual retirement accounts (IRAs). But you can also have a robo-advisor that offers TDFs, as is the case with M1 Finance.
As you can see, there is quite a bit of overlap. If you aren't sure how best to prioritize your strategy, be sure you take full advantage of matching contributions from your employer if that is available to you. Likewise, take advantage of the tax advantages of retirement accounts before putting money in a brokerage account.
Target date funds are actively managed, while robo-advisors use an investment algorithm. This means the two are inherently different in how they work. However, the real question is just how different are their investment strategies?
Robo-advisors are different from target-date funds from the start. Most robo-advisors ask investors to fill out a survey that asks questions about their income, risk tolerance, and time horizon. Then, it will suggest a portfolio optimized for the answers the investor provided. Investors can sometimes change the allocation, but it will already be optimized based on your answers.
Once you finalize your allocation, the robo-advisor goes to work. They often use Modern Portfolio Theory (MPT), continually monitoring and optimizing portfolios. In doing so, they ensure your portfolio always has the optimal allocation and follow a passive indexing strategy.
The bottom line is that robo-advisors use an algorithm to ensure your portfolio is constantly optimized and performing its best. They do this all without needing human intervention. And these days, robo-advisors like Betterment have the option to reduce your risk over time, similar to what a TDF does.
Target-date Fund Strategy
Target-date funds work differently than robo-advisors. Instead of using an algorithm to ensure your portfolio always matches a target, TDFs have a roadmap laid out where their allocation will change at certain points. In doing so, they reduce your risk over time to reduce volatility.
However, not all TDFs are created equal. These funds will invest in a set of mutual funds and reduce your exposure to stocks over time. But different TDFs will adjust your exposure differently. Even two TDFs with the same target date may not work quite the same way.
Thus, before investing in a TDF, it's a good idea to review its investment strategy. Most TDFs will have some sort of document or tool that breaks down how your investments change over time.
Which is Right For You?
Whether robo-advisors or target-date funds are better is a tough call, and it's not easy to choose a clear winner.
In reality, it likely comes down to your own style: do you prefer the latest and greatest technology constantly monitoring, fine-tuning, and optimizing your portfolio? If so, a robo-advisor is for you.
Or are you more old-school and prefer to have plan laid out ahead of time that will be carried out over the years? In that case, a target-date fund is the best choice for you.
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.