Robo Advisors vs Index Funds

Most investors rely on index funds as a low-risk investment option—something that even the great Warren Buffet touts as a safe option for the retired folks. While that is true, those willing to take calculated risks do not entirely benefit from this investment option.

Yet, they end up opting for it due to the high costs involved in hiring an investment advisor. Not to mention the lack of control over those managing their hard-earned money. However, this trend seems to be rapidly transforming into a more sophisticated and scientific investment approach involving robo advisor solutions.

The cons of index funds

The cons of index funds

Index funds such as ETFs are instruments to invest in. Index funds track one or more indices, which could be sectorial or consolidated. The investor does not cash-in on individual stock performance and loses out on opportunities to earn better returns from liquid stocks and other short-term investment opportunities.

An index fund is much more volatile and susceptible to sharp unpredictable movements and macroeconomic changes. For instance, if a company attracts institutional buyers who usually invest large sums, the stock price of that company would gain momentum. Likewise, if there is a bankruptcy filing, then shorting the stock would be profitable. A few underperformers in an index fund can diminish the premium, thus it is important for a portfolio to be rebalanced.

Automated portfolio rebalancing

Portfolio rebalancing is required to factor in fluctuations in the market. Most robo-advisors rebalance an investor’s portfolios automatically to ensure that the target asset allocation is maintained over time. A portfolio’s asset allocation also needs to be reconstructed from time to time to account for changes to an asset class’ valuation or economic conditions. Although this can be done by the investor, it takes time and knowledge to do it right and is an essential part of a smart long-term investment strategy.

Robo-advisors help in being systematic and mitigates classic behavioral biases that push retail investors to buy or sell based on market hype and movements. Automation is a core function of robo-advisors. It minimizes and removes the room for error that typically occurs in portfolio rebalancing and reconstruction, providing the most ‘unbiased advice’. This automation ultimately increases the probability of higher long-term returns.

With index funds, it is essential for investors to closely monitor their portfolios. This ‘manual’ strategy requires an investor to make asset allocation and rebalancing decisions independently or copy the portfolio construction of another investor. An investor can rebalance autonomously with a simplistic periodic rebalancing—once a quarter for example—but would need to monitor their portfolios very closely.

Low management fees

Both index funds and robo advisors have management fees. The big difference here is the amount, as robo advisor platforms have much lower management fees. In addition to brokerage and management fees, there are often forex conversion fees. Most robo-advisors are able to reduce the forex spread, intra-day volatility and bid-ask spread due to their scale—for example, better buying power on the forex spread—and their technology—for example, optimized execution of orders through automated algorithms.

Tracking hundreds of stocks and picking the right ones requires expertise or a dedicated investment team. While index funds can certainly be a smart option for investors who do not mind doing their own portfolio maintenance, it is important to realize that robo advisor platforms truly put an investor’s investment plan on autopilot and can be worth the extra cost to many people. As an average investor may not always be able to afford an investment advisor, robo advisors help to fill this gap.

Benefits of robo advisor platform

Benefits of robo advisor platform

As any technophile would suggest, technology can solve almost any problem. And that is precisely what robo advisor solutions do for investors who desire better returns. Robo advisors are platforms that help investors assess their risk appetite, create a portfolio accordingly and subsequently choose different strategies, assets and instruments to invest in.

Various investment products

Built with algorithms that help investors keep track of various asset classes based on a pre-defined risk appetite, most robo-advisors today use various asset allocation strategies to manage portfolios. Asset allocation has been proven to account for the vast majority of portfolio returns. A robo advisor’s asset allocation strategy saves an investor a significant amount of time in deciding which index funds or asset classes to invest in to diversify a portfolio.

Unlike index funds which limits an investor to the equity market, the robo advisor platform allows an investor the flexibility to invest across various markets such as the money and commodities markets. This eliminates the need to rely on the performance of a particular index. Thus, just like a bank, an investor can invest proportionately in various markets, without having to monitor any of them manually.

Tax benefits

Tax benefits

Apart from automatically rebalancing a portfolio, the robo-advisory service also incorporates other features such as tax optimization, which can be tricky for even experienced investors to do on their own. Most robo advisors platforms provide investors access a form of live help to answer questions any enquiries they may have.

Robo-advisors provide a simple-to-use, cost-effective, and intelligent way of investing. The key advantage of deploying robo advisor solutions compared to investing in index funds is the higher probability of better returns, low advisory costs, data-driven decisions, and diversification of an investment portfolio. Investors will most likely benefit from being hands-off and unbiased in their own investment management to achieve their investment goals.