According to Bank of America, passively managed investment funds now represent some 45 percent of the entire U.S. equity market. Even though the bulk of this money is invested via index funds, automated investment instruments, such as robo advisors, are a fast-growing slice of the passive investment pie.
In response to the surging popularity of robo advisor platforms, index-replicating exchange-traded fund (ETF) providers have also started offering a similar range of automated investment advisory products.
The main difference between robo investing and index funds is: Unlike index funds which limit an investor to the equity market, using a robo advisor allows an investor the flexibility to invest across various markets such as the money and commodities markets. This eliminates the need to rely on the performance of a particular index.
To help you better understand the all in one ETF vs robo advisor debate, we’ve broken down each product’s competing investment strategies, their respective pros and cons, and their contemporary performance during the ongoing global economic crisis.
Breaking Down Passive Investing
As an investing strategy, buy and hold passive investing has become increasingly popular over the last decade. Broadly speaking, passive investing revolves around the idea that it is exceptionally difficult to anticipate and subsequently beat the everyday performance of the equity market.
To avoid losing money, passive investors simply aim to track and match the returns from a particular market or sector. Although the specifics will depend on the market you’re invested in, most passive investment portfolios share the following three features: low-cost fees, multi-sector diversification, and simplified rebalancing.
Can You Trust Passive Investing When the Global Economy is in Shambles?
As an investing methodology, passive investing allows you to bypass the fund manager middleman and reap the benefits of a historically high performing investment strategy.
Remember, when the global economy is in shambles, a passive investing strategy will not provide guaranteed returns.
However, it will save your hard-earned cash from being gobbled up by exorbitant front-end loading, expense ratios, management fees, and account fees.
Why Are So Many Millennials Now Entering the Market?
Prior to the sharp pullback in equity markets earlier this year, there was a widespread belief amongst millennials that they had been locked out of the stock market. After experiencing the brunt of the 2008 housing market crash, many millennials were left feeling like they’d missed their opportunity to benefit from the lucrative pre-pandemic bull run.
So, when markets began tanking in February and March, it was millennial investors, spurred on by the fear of missing out and fortified by knowledge of an incoming $1,200 stimulus check, who rushed to buy up shares in iconic airlines and distressed blue chip companies.
To cut back on fees and expedite the settlement process, millennials largely ignored conventional brokers, instead using slick robo advisor platforms and round-up investment apps.
What is DIY Index Investing?
Index investing is the formal term for using index funds to accumulate diversified holdings across one or more major equities benchmarks. Unlike managed funds, the composition of an index fund is derived from the underlying index the fund is mimicking.
This means that index funds do not require stock pickers or fund managers, leading to ultra-low-cost management fees and expense ratios.
To get started with DIY index investing, you can either purchase units in an index tracker mutual fund, or you can begin accumulating index-mimicking shares via an ETF. For example, an investment in VOO, Vanguard’s S&P 500 index ETF, would give you exposure to the same 500 publicly-owned companies that currently comprise the S&P 500 stock market index.
Remember, even though the S&P 500 is the most well-known index, DIY index investors can choose from a massive range of other index fund products. Thanks to the rampant financialization of the global economy, there is an equities index—and a corresponding index fund—for almost every financial market in the world.
What is a Robo Advisor?
A robo advisor is a type of financial advisor that uses input-dependent algorithms and machine learning to fulfill a range of investment advisory functions. These functions include general investment advice, limited asset rebalancing, and model portfolio generation.
Before a robo advisor can execute these functions, you will be asked to answer some questions about your investment objectives. You’ll also need to provide some information about your risk disposition, your preferred sector targets, and your expected trading horizon.
You’ll also want to find and compare the best robo advisors and automated portfolio builders based on fees, customer service, user experience, and everything in between.
Pros and Cons: DIY Index Investing vs. Robo Advisor Services
Unless you’ve been living under a rock for the last decade, you’ve probably heard a lot of chatter about the outsized performance of passive index investing and the surging growth of robo advisor platforms.
However, just in case you have been taking residence under a rock, we’ve broken down the respective pros and cons of both DIY index investing and robo advisor investing.
Advantages of DIY Index Investing
Streamlined Investment Process
Index investing is unique in the financial world in that it really is a simple process. To call yourself an index investor, all you need to do is select one or more index funds and begin a regular contribution schedule. If you choose an all in one ETF, you won’t even need to worry about asset allocation and portfolio rebalancing.
Affordable Management Fees
The main role of an index fund manager is to replicate an existing index, a job that simply does not require an extensive team of researchers or analysts. These personnel savings are then passed on to investors in the form of low-cost management fees.
Investing in an index fund is the quickest way to gain diversified exposure to some of the biggest companies in the world. If you already hold investments in a certain industry, you can diversify your portfolio by putting money in alternate sector-specific index funds.
Downsides of DIY Index Investing
Market Capitalization Dependence
In most cases, the weighting composition of an index is determined by an analysis of market capitalization. The bigger the company, the heavier its weighting in the index. However, if an index is heavily weighted towards a small handful of industry juggernauts (e.g. banking or mining stocks), it can drastically increase your risk exposure to sector-specific price events.
As index investing has grown more popular, there has been a significant surge in the amount of capital, from both retail and institutional investors, being committed to index funds. With passive investment instruments drawing ever larger capital inflows, there is growing concern that conventional metrics for price discovery and risk assessment have become distorted.
One person who shares this concern is Michael Burry, the legendary investor and hedge fund manager who made a small fortune by shorting toxic mortgage-backed assets prior to the 2008 housing crisis. According to Mr. Burry, the emerging bubble in passive index investing has fueled rampant overvaluation across benchmark equity indices, especially amongst overrepresented index-heavy large-cap companies.
When you invest predominantly through index funds, you are voluntarily discarding your ability to accrue shareholder voting rights. Instead, these voting rights go to the investment firms and institutions which manage the underlying index fund. This distinction has led to a concerning level of concentrated corporate ownership amongst the big three U.S. asset managers: BlackRock, Vanguard, and State Street.
Advantages of Robo Advisor Services
Low-cost Management Fees
While not quite as low as index funds, the fees for robo advisor platforms are still reasonably affordable. Depending on the platform you choose you can expect to pay between 0.25 percent to 0.5 percent (of assets under management) in fees.
Expedient Secondary Functions
In addition to their primary set of functions, robo advisors can also be programmed to support a range of secondary services. While specific offerings will vary between platforms, most robo advisors offer a retirement planning calculator, tax-loss harvesting, and general financial information consulting.
Data-driven Investment Models
The underlying algorithms governing robo advisors are not always perfect, but they are always getting better. As these investment models become more advanced, robo advisors are expected to develop superior predictive decision-making, leading to more adaptive rebalancing and more profitable portfolio generation.
Downsides of Robo Advisor Services
Limited Wealth Management Features
Robo advisors are designed to provide a one-size-fits-all solution to investment management. Accordingly, robo advisor platforms rarely offer wealth management services, thereby limiting your ability to receive customized tax assessment or jurisdiction-specific regulatory assistance.
Depersonalized Investing Service
As the name suggests, robo advisor platforms are designed to operate with minimal human oversight. Without this human touch, robo advisor platforms are prone to potentially insensitive portfolio recommendations and frustrating customer service experiences.
Losses Via Rebalancing
Automatic rebalancing is a commonly supported feature across a wide variety of robo advisor platforms. Ideally, your portfolio rebalancing strategy should be designed to optimize returns within pre-specified risk parameters. However, in the case of robo advisors, your portfolio will only be adjusted when the rebalancing interval is triggered. Depending on market conditions, automatic rebalancing can cause you to lock in an avoidable loss or miss out on an easy gain.
Key Takeaways: Which Investing Strategy Performed Best During the Recent Economic Crisis?
Even though they’re often exposed to the same indices, index investors and robo advisor investors will rarely record the same performance outcomes. For instance, during an economic crisis, individuals invested through a robo advisor can use their platform’s portfolio rebalancing function to swap out overexposed stocks for more stable fixed interest assets. On the flip side, index funds are usually more effective at cushioning downturn losses due to their considerably lower expense ratios.
Given their assorted pros and cons, it’s exceedingly difficult to give a definitive answer regarding the contemporary performance benefits of index investing vs robo advisor investing. Firstly, and perhaps most importantly, it’s unclear where we are on the timeline of coronavirus-induced economic downturn. If countries like the U.S. are unable to suppress or eliminate persistent COVID-19 infection clusters, it could lead to a second round of lockdowns, an outcome that would likely trigger a longer-term pullback in rallying equity indices.
Alternatively, if early vaccine trials prove particularly promising, index funds and robo advisor portfolios are expected to benefit from a surge in retail enthusiasm and speculative capital.
Secondly, central banks around the world are in the midst of running an unprecedented liquidity injection and quantitative easing experiment. So far, this experiment has played a major role in the rapid rebound in equity prices. However, it is also propelling dangerous levels of optimistic post-lockdown speculation, muddying the “true performance” of both index funds and robo advisor portfolios.
Finally, in order to answer this question, we’d also need to categorize and quantify a long list of externalities, a breakdown that would examine everything from the details of the benchmark index and robo advisor platform to the specific investor preferences regarding risk and asset allocation. In the meantime, we recommend that you avoid relying too heavily on regular interval rebalancing, robo advisor or otherwise, in the midst of hyper volatility and a precarious global economic landscape.