What Robo-Advisors Really Bring to the Table

There’s no doubt so-called robo-advisors like Wealthfront and Betterment are doing good. But I don’t understand the rapturous applause they’ve received over the past couple of years. Yes, these web-based advisors automate services like risk-tolerance assessment, asset allocation, fund selection, rebalancing, and automatic tax-loss harvesting. But, barring the latter, these services have long been offered by the likes of Vanguard, even if through crude and unintuitive websites. For example, I can go to Vanguard’s website and find myself haltingly guided to one the firm’s Target Retirement and LifeStrategy funds. The robo-advisers have streamlined this inelegant process through their beautiful and easy-to-use websites and used exchange-traded funds to recreate target-date funds.

The one unique service robo-advisors bring to market is cheap, automated tax-loss harvesting. This is a big benefit to high-income taxable investors and is likely competitive with the services by firms like Aperio Group and Parametric Portfolio Associates. In fact, Wealthfront and Betterment may already offer (or soon will) superior tax-loss-harvesting services, because they can use their richly priced equity to hire the best engineering talent out there. The rich are the true direct beneficiaries.

For whatever reason, the media has chosen to frame robo-investing as the young adult's alternative to the flesh-and-blood financial advisor. This is a misleading comparison. Robo-advisors mostly offer cookie-cutter portfolios based on short questionnaires and little to no financial planning. The typical young adult does not have a big taxable portfolio (if at all) and finds it most advantageous to save via a 401(k) or IRA, so tax-loss-harvesting isn't a big deal. For the supposed target audience, most robo-advisors in substance behave like target-date funds.

However, robo-advisors have the potential to do tremendous good for society. Most advisors do not publicly disclose in detail their investing and tax-mitigation strategies, which make them hard to assess. Betterment and Wealthfront lay out in detail what they do and why. By being framed as "advisors," they prime investors (and the media) to compare them to traditional financial advisors. This knock-on effect has the potential to be hugely disruptive for the wealth-management market.

Historically, the financial advice business lacked a good benchmark, contributing to a hideously inefficient market where ultra-competent and barely competent advisors can both command 1% asset-management fees, provided they have the right sales and people skills. In fact, the relative homogeneity of financial-advisor fees indicates wealth management is what economists call a credence good, a type of good or service that is difficult if not impossible to properly assess before or even after consumption.

Credence good markets spring up when the sellers are much more knowledgeable than the buyers about the quality of the product. Insurance is a classic example: Unless you're an expert, you are not equipped to properly assess whether you got a good deal, whether the policy actually does what the insurance agent tells you it does, and whether that policy truly fits your needs better than alternatives. Because the temptation to take advantage of clueless clients is overwhelming, insurance salesmen as a whole have earned an unsavory reputation.

Most rich societies try to handle these market failures by ensuring experts have a baseline level of competence and enshrining in law a fiduciary standard of care, such as with doctors and lawyers. There are no such protections for consumers in wide swathes of the financial advice market. Fortunately, competitive forces are driving the market to greater efficiency without the heavy hand of government.

We're already seeing the incumbents respond. Vanguard last year rolled out Personal Advisor Services at a cost of 0.30% for a human advisor, albeit one dispensing cookie-cutter advice. Schwab is planning to launch its own free robo-advisor-like service. Fidelity recently partnered with Betterment to offer “white-label” portfolio management, where advisors can put their clients into Betterment portfolios and take the credit.

Robo-advisors will eventually supplant many human financial advisors in the same way TurboTax did with accountants. But that time will be years coming, and not until they offer more financial-planning services.

Disclosure: Morningstar, Inc.'s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.