Both almost always rely on a passive approach to investing. Both seek to deliver a diversified mix of securities that track major segments of the stock, bond, or other financial markets. And both strive to match market returns, rather than to beat them. Most robo-advisors rely mainly on exchange-traded funds (ETFs) or mutual funds that track an index to anchor an investor’s portfolio.
The decision to go with a robo-advisor or index funds comes down to several considerations: Is the person comfortable and experienced with investing? Do they need advice or support? And how much time and money do they want to devote to selecting and maintaining their portfolio?
What is a robo-advisor?
Robo-advisors are digital services that provide basic money management functions and develop a diversified portfolio for clients using an algorithm instead of a human. Although they may vary in size, scope, and services, all of them use computers to select investments based on a client’s answers to survey questions about risk tolerance, time horizon, financial goals, and other requirements. Computers select assets and make asset allocations, in most cases from a limited pool of exchange-traded funds (ETFs) or sometimes mutual funds that are designed to track an index.
Robo-advisors usually charge an annual management fee of about 0.25% to 0.5% of the customer’s assets. That’s less than the 1% or more a human advisor may charge. The robo-advisor fee generally covers basic account creation, oversight, and maintenance.
Robo-advisors operate as standalone entities or may be offered by big money managers.
What is an index fund?
No one can invest directly in a financial index such as the Standard & Poor’s 500. But asset managers and fund providers such as Vanguard and Blackrock have created hundreds of funds based on indexes and made them available to investors.
An index fund is simply a basket of securities that seeks to provide exposure to the stocks, bonds, or other assets within a particular universe. Some funds invest in all of the securities in a market index, while others invest in only a sample of securities in the index, such as tech stocks.
Index funds are structured as mutual funds or ETFs. ETFs trade throughout the day on an exchange like stocks while mutual funds trade once a day as markets close. ETFs generally carry lower fees than mutual funds, although the differences will be minimal for passively managed mutual funds versus those that are actively managed.
Index funds have soared as a share of the overall fund market. In 2010, index mutual funds and ETFs accounted for 19% of the market’s $9.9 trillion in total net assets. By 2020, that share had jumped to 40% of the market’s $24.9 trillion in total net assets, according to an analysis by the Investment Company Institute.
Popular index funds track major equity indexes including the S&P 500, which includes 500 of the biggest U.S. companies; the Nasdaq 100 Index of large non-financial companies on the Nasdaq stock market; and the FTSE Global All Cap Index of large -, mid-, and small-cap stocks.
Investors can buy index mutual funds through money management firms or the fund company that created them. Investors can purchase ETFs directly through either a traditional or online brokerage account.
Robo-advisors vs. index funds: Key differences
Robo-advisors differ from stand-alone index funds in key ways.
- Choice. With a robo-advisor, computers select the funds for a client’s portfolio based on personal specifications. And algorithms routinely adjust, or rebalance, the investment mix to keep the portfolio in line with the investor’s specifications. With index funds, an investor chooses which index fund to buy or sell, and when.
- Additional capabilities. Robo-advisors typically offer online tools to help the investor clarify their priorities and long-term goals. Robo-advisors also often offer strategies to reduce an investor’s tax liabilities through tax-loss harvesting. Index funds do not.
Potential benefits and limitations of robo-advisors
Robo-advisors allow for personalization and come with additional capabilities, but investors pay for this in management fees.
- Personalization. Robo-advisors create a portfolio based on a client’s age, goals, risk tolerance, time horizon, and other individualized data.
- Advice. Robos offer online advice, research, and planning tools; most provide access to a human consultant at an extra cost.
- Maintenance. Robo-advisors rebalance a portfolio to keep it in line with a client’s goals. They may also provide tax-loss harvesting, reducing taxes owed on any capital gains.
- Low minimums. Most robo-advisor accounts have low, or even no, minimum balance requirements.
- Fees. Robos charge a management fee on top of fees clients pay to own the securities in the portfolio. Extra personal help costs more.
- Limited choices. Robo-advisors generally rely on a limited number of pre-selected ETFs, reducing choice.
Potential benefits and limitations of index funds
Index funds don’t have management fees, but investors are responsible for maintaining their portfolios independently.
- Lower cost. Index ETF expense ratios are lower than robo-advisors, and some have no fees at all.
- More variety. Investors can choose from thousands of index funds beyond the staples used by robo-advisors.
- Control. The investor, not a computer, chooses the funds and decides when to buy and sell.
- No support. Investors in index funds must do their own research and make their own selections and purchases.
- Maintenance. People must monitor and adjust their portfolios to keep them in balance and optimize tax benefits.
- Higher minimums. Index mutual funds often have high account minimums.
What to consider when deciding between the two
The choice between a robo-advisor and index fund c to a person’s investing confidence, time, and money.
Individuals with experience and interest in selecting their own portfolio may find index funds meet their needs. The funds track the world’s biggest stock, bond, and other markets, allowing an investor to capture the markets’ returns in a single security. Index funds give the investor a wide range of choices and save the management fee associated with a robo-advisor.
People who are less confident about investing or those who want planning and other advice will find a robo-advisor that offers online support and long-term investment management. Robo-advisors can clarify one’s investing objectives, and select a portfolio to meet them. They can also save clients the time and effort required to keep a portfolio in sync with their goals. Of course, investors have to pay more for this hand-holding.
The bottom line
Robo-advisors and index funds are both passive investing strategies. Index funds will by definition never outperform the underlying index, nor will robo-advisors that rely on index funds to underpin a client’s portfolio. And of course, indexes themselves are not guaranteed to rise, although major equity indexes such as the S&P 500 have appreciated over time.