Robo advisors have been steadily gaining in popularity over the past few years. But how they compare to index funds? Index funds have long been the gold standard of long-term investors. But perhaps, robo-advisors vs. index funds are a better option now for most investors. Well, I did some research, and here is what I found:
Robo advisors have several advantages over index funds. They allow for fractional share investing and can automatically rebalance your portfolio. This leads to higher returns since your entire capital is put to work. Another benefit of robo-advisors over index funds is tax-loss harvesting which reduces your tax burden as an investor. On the other hand, most robo-advisors also charge a fee for those services of up to 0.045% per year.
Robo-Advisors vs. Index Funds – Overview
|Feature||Robo Advisors||Index Funds|
|Fees||0 – 0.45%||0%|
|Fractional Share Investing||Yes||No|
Pros & Cons
In this post, we’ll compare some of the differences between robo-advisors vs. index funds. We’ll go through the above list one by one and examine some of the pros and cons of each feature.
One of the biggest advantages of robo-advisors over index funds is automated tax-loss harvesting.
Tax-loss harvesting describes the process of selling and rebuying stocks or funds that have lost value to create a paper loss for that year. This means that you will be able to accumulate losses on paper so that when you actually sell a fund for profit your capital gains tax burden will be reduced significantly.
Almost all robo-advisors offer this feature and execute the perfect tax-loss harvesting strategy for your portfolio.
With index funds, tax-loss harvesting is possible too. It is just much harder to do. And we will lack the precision and algorithmic knowledge that robo-advisors have to optimize our strategy. Not to mention the time and effort that would go into selling and rebuying our index funds at optimal times during the year.
Robo-advisors have a clear advantages here over index funds.
Another feature that robo-advisors excel at is automatically rebalancing your portfolio.
You will be able to decide on a specific allocation for your asset classes – let’s just say 60% U.S. stock, 20% international stocks, and 20% bonds – and your robo-advisor will maintain those ratios no matter what.
As stocks tend to perform bonds over time, this happens automatically by selling certain assets (stocks) of your portfolio that are outperforming others and then buying more of the assets (bonds) that are lagging behind to balance out your allocations.
This way you can make sure that you will never become over-exposed to a specific assets class.
Of course, this can be done manually with index funds well. But as I pointed out above the time and effort that goes into doing this regularly could be put to use in better ways.
As a compromise, you could consider rebalancing only once a year. But asset allocations may skew quite a bit in 12 months.
Besides auto-rebalancing, another great feature that is available for both robo-advisors and index funds is auto-investing.
This describes the simple process of transferring a fixed amount from your bank account to your brokerage account and then automatically investing it in whatever portfolio you have chosen.
All robo-advisors I have tested so far have this feature and make it incredibly easy to stay on target with your investment and financial goals.
This also ensures that all of your capital is put to work.
With index funds, it entirely depends on your broker. If you have made the wise decision of investing in Vanguard’s index funds and chose to do so directly through Vanguard’s brokerage, you are in luck! Auto-investing is available at no extra cost to you.
Although not all traditional brokers offer this feature it is certainly not something that robo-advisors have the clear upper hand in. However, most of them do simplify the entire process.
Another feature that ties in with the above is fractional share investing.
Usually, you are only able to invest in an index fund once you reach the minimum investment threshold of on share. For Vanguard’s Total Stock Market Fund (VTI), the price of one share currently hovers around $150. As a result, any remaining capital under $150 cannot be invested.
With fractional share investing you are able to invest every single dollar since there is no minimum investment as dictated by the price of a share. Robo-advisors do this by pooling together investor funds in order to optimally distribute it among assets.
One huge benefit of this is that you will have no “dead capital” lying around not earning you interest. If you regularly have $100 or more that can’t be invested and we assume the historical average return of the stock market at 7.5% you’ll lose around $7.50 per year in potential profits.
Not a huge deal, I know. But still worth considering!
Both robo-advisors and index funds charge fees.
The most obvious downside of robo-advisors is that most of them charge higher fees than index funds. Those are charged for running all their automated services for you so that you can focus on your investment goals.
With robo-advisors, the fees can be as high as 0.45% per year. This means you would pay around $45 in fees on a $10,000 portfolio. Of course, this is on top of the fees you pay for each index fund that is held through a robo-advisor.
With index funds, the fees are expressed as an expense ratio. Most of them range anywhere from 0.03% up to 0.35% and beyond with an industry average of 0.28%. However, if you pick your index funds wisely you can end up paying close to nothing in fees.
Robo-Advisors without fees
Luckily, there are also robo-advisors out there that do not charge fees for their services but instead make their profits elsewhere. This enable us to harness the power of all of the above features at the same base cost of index funds.
One of the few robo-advisors that does not charge fees is M1 Finance. I love them because they offer all of the above features at no extra cost to the investor. Additionally, you have the option to borrow against your equity at very low interest rates.
There many benefits to investing with robo-advisors compared to index funds.
You can increase your investment returns through fractional share investing and subsequently keep more of your profits through tax-loss harvesting. Auto-rebalancing provides additional stability and reduced risk through over-exposure.
Auto-investing is a great feature to keep on track with your investment goals and retirement planning. You can make use of this feature with both robo-advisors and index funds.
The only downside to using robo-advisors is their fees. Fortunately, there are even some robo-advisors out there that offer all of the above benefits and charge zero fees. I personally use M1 Finance for all my index fund investments.
Whether you use robo-advisors or not is up to you. Index funds on their own are great investment vehicles that will get you closer to your long-term goals.
But why not combine index fund investing with the unparalleled power of robo-advisors?