What Is a Robo-Advisor?

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In this clip, Michael Douglass and Matt Frankel discuss Wells Fargo's (NYSE: WFC) entry into the robo-advisory business, and why robo-advisories have become so popular in recent years. They also discuss the evolution of the robo-advisory concept over the years, as well as the new "hybrid" robo-advisory structure.

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A full transcript follows the video.

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This video was recorded on Nov. 13, 2017.

Michael Douglass: We thought we would talk about robo-advisors a little bit today because there's news. Wells Fargo is planning to use a robo-advisor. To be more precise, they're planning to create a robo-advisor. It's called the Intuitive Investor product. Clients are going to need to have a minimum of $10,000 to open an account. They'll be charged a 0.5% advisory fee. A little bit less in certain circumstances, and we'll talk about that a little bit further down the road. But what's interesting here is, Wells Fargo is following in the footsteps of a lot of small competitors, like Betterment, that you've probably heard of, and also some very large institutional competitors like Vanguard, Charles Schwab, Fidelity, which has that product called Fidelity Go, and Merrill Edge Guided Investing by Bank of America. What's interesting about robo-advisors is, they're a big market. In fact, it's one that's growing pretty quickly. One estimate puts it at $385 billion in assets under management by 2021. Before anything else, let's talk a little bit about what a robo-advisor is. Matt?

Matt Frankel: Before 2008, all you had were human wealth managers, I guess you would call them, where they would charge you a certain percentage of your assets under management in exchange for giving you financial advice and managing your investments for you. Generally, this was between 1%-2% per year, on top of all the fees charged by whatever mutual funds or ETFs they invested in for you. So, to solve that problem, I believe Michael actually told me he used one that charged him a lot.

Douglass: Yeah, it was something like 1.5% annually, again, in addition to the fees of the underlying mutual funds. So, I ended up paying something like 3-3.5% annually. Which, when you think about it, can be a lot of money long-term and can really damage your investing returns. When you think about the fact that the stock market historically returns about 6-6.5% after inflation, theoretically, that's eating about half of those returns.

Frankel: Right. I actually just published an article this morning that shows how you can lose hundreds of thousands of dollars over the course of a lifetime based on advisory fees alone. So, to solve this problem, this whole robo advisor concept was born. It started out in the form of what's called a target date fund that essentially invests in a combination of other mutual funds, and adjusts over time as you get older, lower your risk tolerance and make the prudent investing moves that a financial advisor would do.

Douglass: Yeah. And then, what's interesting is, the next step was, these formal robo-advisors. Betterment launched in 2008. The idea was essentially this automated solution that automatically rebalances your portfolio among different funds, at the time usually target date funds. Of course, since then, things have changed. So, you can kind of say, "Here's my risk tolerance, here's what I'm thinking about," and they'll recommend this allocation and work with it. Nowadays, of course, robo-advisors come in a variety of different shapes and flavors because it's been so popular. So, you actually see a move by some institutions toward hybrids, so, robo-advisors that charge low fees, but also provide some access to a human financial planner so that you can talk through some of the thornier tax issues that pop up from time to time when you're investing, and when you have a lot of complicated stuff, basically, in your financial life.

Frankel: Right. This would be a situation where, you still need some access to a person, you pretty much want your investments on autopilot for the most part, but there are some situations where, say, you inherit some money and you want to know the best thing to do with it, or you're faced with a big tax bill this year because you've sold some of your other investments and need to know what to do. It provides you access to an actual person where you can ask questions like that.

Douglass: Yeah. And as you can imagine, in most cases, that results in a slightly higher assets under management fee than for your typical robo-advisors. Now, just to be clear, to give you a sense of what robo-advisors are usually charging, it's usually pretty close to that 0.5%. Now, some of them are a little bit lower, some of them are a little bit higher, but to give you a sense, you're moving from a 1-2% assets under management fee for a traditional wealth manager down to around 0.5%. So that's really a substantial savings for most investors. And I think that's one of the key upshots that everyone should be aware of.

Matthew Frankel owns shares of Bank of America. Michael Douglass has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.