People often view robo-advisors and target-date funds (TDFs) as similar options when considering an investment strategy.
Both offer a simple approach to hands-off investing. Both strive to create a diversified portfolio that balances the risks needed to build wealth with assets that protect savings. And both cater to people who don’t want to act as their own financial advisor or investment manager.
But how do they differ? And why might a person choose one approach over the other?
What is a robo-advisor?
Robo-advisors are digital services that rely on algorithms rather than humans to build and manage a client’s portfolio and provide investing advice.
Robo-advisors survey each investor to determine risk tolerance, time horizon, and other preferences. Computers use the data to formulate a mix of assets—generally low-cost stocks and bonds inside exchange-traded funds (ETFs)—designed to meet the individual’s goals.
Most robo-advisors are passively managed. Computers perform routine account maintenance such as rebalancing and tax-loss harvesting, which can reduce taxes owed on any capital gains. Contact with a human advisor may be available for an added fee. Robo-advisors operate as stand-alone firms or may be a strategy offered by big investment companies such as Vanguard and Fidelity.
What is a target-date fund?
Target-date funds are mutual funds that are made up of other mutual funds and ETFs and are generally structured as a fund of funds. They’re designed to guide an investment portfolio to a certain end date—usually retirement, but other milestones such as saving for a child’s education.
Investors choose the year closest to the date they’re saving for. The fund invests in a pre-selected asset mix calibrated for that date. Most TDFs are actively managed to a certain extent. The fund manager adjusts the assets over time in what’s known as a glide path. The portfolio generally becomes more conservative as the target date approaches.
Investors buy target-date funds through a broker, investment company, or employer-sponsored retirement program. They are often the default setting in a company’s 401(k) offerings.
Robo-advisors vs. target date fund: Similarities and differences
Robo-advisors and target date funds have a number of features in common, but also some key differences in two important areas.
Portfolio strategies
Both robo-advisors and target-date funds can provide investors with a portfolio that works toward their goals.
With a TDF, the goal is an endpoint, usually retirement, when a person will want to access their savings. The investor chooses a target year that’s generally decades in the future. Most target funds work on a glide path where a manager gradually scales back the portion of the portfolio invested in equities and adds to the fixed-income securities to reduce risk as the target nears. Once the goal is reached, some target funds freeze the asset allocation while others continue adjusting it.
Robo-advisors invest based on the client’s personal goals, not the individual’s age or a year in the future. Computers choose the mix of equity and fixed-income securities in the portfolio based on the investor’s risk tolerance, time horizon, and other specifications. The initial asset allocation remains static unless the investor asks to change it by updating their specifications. Computers determine a suitable asset mix to meet the new goals. Robo-advisor portfolios generally do not automatically adjust, unless they have strayed from the investor’s desired asset mix, and don’t have a specific end date.
Fees
A robo-advisor will generally cost more to own than a target fund with a low expense ratio. That’s because a robo-advisor charges a management fee that averages about 0.25% to 0.5% a year. The fee covers the selection and maintenance of the portfolio, as well as automatic portfolio rebalancing and strategies to reduce taxes on capital gains known as tax-loss harvesting. Robo-advisors also offer online advice available to investors. Expenses associated with the underlying funds and personal contact with a human advisor can add to the price tag.
Target-date funds don’t offer advice. But they usually rely on people to manage the funds and adjust the investment mix en route to the target date. TDFs that invest in mutual funds command higher expense ratios than those that invest in ETFs. These fees can amount to more than the basic management fee charged by a robo-advisor. The average asset-weighted expense ratio for target-date funds was 0.52% at the end of 2020, an analysis by Morningstar found. However some TDFs have expense ratios that are less than a quarter of that percentage.
Benefits and drawbacks to robo-advisors
Robo-advisors offer more advanced personsonalization than TDFs, but they’re generally more expensive.
Potential benefits
- Individual focus. Robos survey clients to determine goals and create an appropriate portfolio.
- Advice. Robo-advisors provide investment advice and planning via online sources and sometimes a real person.
- Low minimums. Low, or even no, minimum investment requirements to open an account.
Potential drawbacks
- Passive. Robo-advisors rely mainly on a limited selection of ETFs in a passive approach that may meet but not beat an index or market.
- Fees. Investors pay a general management fee on top of expense ratios charged by ETFs or other securities the robo invests in.
Benefits and drawbacks to target date funds
TDRs are driven by a specific goal, with a specific timeline, and are actively managed to meet it. But they come with layers of fees and no added services.
Potential benefits
- One-stop shop. All investment dollars go into a single fund designed for a specific purpose.
- Variety. TDFs provide exposure to myriad assets held in a wide range of mutual funds and ETFs.
- Active. Investment managers strive to outperform the market.
- Availability. Most employer-retirement plans offer target fund options.
Potential drawbacks
- No frills. Target-date funds don’t offer advice, planning, or other guidance.
- Limited choice. Investors may be limited solely to funds created by the provider.
- No uniformity. Funds with the same target date can have different formulas and allocations.
- Costs. TDFs may have layers of fees to cover each fund in the portfolio and overall management.
- Higher minimums. Mutual funds can have higher minimum investment levels.
Considerations when choosing a robo-advisor or target-date fund
Investors must weigh how much control and input they want in their investment and how much flexibility the robo-advisor or target-date fund offers.
Robo-advisor considerations:
- Robo-advisor investors planning for retirement savings must weigh how that choice meshes with their investment priorities and other investments, such as an employer-sponsored 401(k).
- Robo-advisors generally will not automatically adjust an account as the investor heads toward retirement. Computers will rebalance the portfolio to keep it in line with the investor’s original specifications. Although investors can alter those specifications and change the asset mix, the responsibility for doing that falls to the investor.
- Robo-advisors, unlike target-date funds, can provide guidance on retirement planning and other goals.
Target-date fund considerations:
- Target-date fund investors choose a date in the future and a corresponding fund geared to that date. Then they rely on the fund’s glide path to minimize risk and deliver adequate returns as the date approaches.
- Target-date funds have several caveats. People must invest their entire nest egg in a single target fund for the strategy to work. Investors who mix target funds with other investments risk skewing the allocation and glide path that TDFs are designed to provide.
- Target funds don’t offer much flexibility. Individuals can’t adjust the investments that make up the fund, sell a piece of the fund they don’t like, or buy more of a security they do like. If they want to change course, they must sell the whole fund and start over. These funds also are of limited use for those already in retirement; they either keep adjusting after the target date or freeze the asset mix at the date. Neither may be right for a retired investor.
The bottom line
Both strategies remove much of the guesswork from long-term investing.
Robo-advisors tend to appeal to individuals who are comfortable with online investing, have specific priorities, and may need advice on the best way to meet them. Investors who are comfortable with selecting a date and staying with it no matter what might be happier with a target-date fund.
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