How To Invest With a Robo-Advisor

A robo-advisor automates the investment process, making it easier to save for retirement or other financial goals. While the concept is straightforward, new investors may find the idea of letting a software algorithm manage investments unfamiliar. Here's a breakdown of what robo-advisors are and how they work.

What Is a Robo-Advisor?

A robo-advisor is a type of brokerage account that automates investment management. Like traditional financial advisors, robo-advisors are regulated by the Investment Industry Regulatory Organization of Canada (IIROC) and must act in their clients' best interests. Robo-advisors typically insure accounts through the Canadian Investor Protection Fund (CIPF).

How Does a Robo-Advisor Work?

The process begins with an automated questionnaire designed to assess your financial situation, goals, and risk tolerance. Based on this, the robo-advisor recommends a portfolio tailored to your needs. For instance, if saving for retirement, it might suggest an RRSP with a portfolio of ETFs geared toward long-term growth. If saving for a home, it might recommend a taxable account with short-term growth in mind.

Some robo-advisors allow customization of asset allocations. For example, if your suggested retirement portfolio is 80% stocks and 20% bonds, you might adjust it to 90% stocks if willing to take on more risk.

Investment Selection

One of the main features of robo-advisors is that they pre-select investments, usually low-cost index fund ETFs. These funds are diversified across various asset types like Canadian and international stocks, bonds, and real estate investment trusts (REITs). Some robos even offer themed portfolios, such as socially responsible options.

The use of low-fee index funds is a key advantage, as they have historically outperformed higher-cost, actively managed funds over time.

Modern Portfolio Theory

Many robo-advisors apply Modern Portfolio Theory (MPT), which focuses on optimizing returns while minimizing risk through diversification. This approach helps smooth out portfolio performance by balancing investments across a variety of asset classes, aiming for steady growth even during market fluctuations.

Robo-advisors also provide features like automatic portfolio rebalancing and, in some cases, tax-loss harvesting to maintain the right investment mix and reduce tax liabilities.

Costs

Robo-advisors typically charge annual fees between 0.25% and 0.50% of assets under management (AUM), though some operate on a fixed subscription fee model. While these fees are generally lower than traditional financial advisors, it's important to review the fine print. Some claim zero fees but may require holding a portion of your portfolio in cash, earning interest for the platform instead of for you.

In addition to management fees, robo-advisor portfolios come with expense ratios for ETFs, typically around 0.21% annually. These fees are deducted automatically from fund earnings.

Common Features

• Automated investing: Regular contributions are scheduled, and portfolios are adjusted automatically.
• Automatic rebalancing: Portfolios are periodically adjusted to maintain the correct asset allocation.
• Tax-loss harvesting: Some robos optimize for tax efficiency by selling losing investments to offset gains.
• Personalized financial planning: Some robos offer tailored financial plans or tiered services for larger investments.
• Goal-based accounts: Many platforms offer various account types like TFSAs, RRSPs, and RESPs for different savings goals.

Robo-Advisor vs. Financial Advisor

Robo-advisors are ideal for simple investment strategies, but for more complex needs, a financial advisor may be more appropriate. A financial advisor offers more customization, a wider range of investment options, and comprehensive financial planning, including areas like tax strategies, estate planning, and insurance.

In summary, robo-advisors are a convenient option for those starting out or seeking a hands-off approach. However, as financial needs grow, a human advisor may be better suited to provide more personalized guidance.