In the first article in our series on robo-advisors, we mentioned how index funds can provide a similar level of diversification as a robo-advisor and are almost guaranteed to cause capital appreciation in the long run. Towards the end of the previous article, we mentioned how investors who decide to use robo-advisors for their investing needs are usually focused on the long-term, and these investors can also make use of index funds.
In this article, I will directly compare robo-advisors with index funds. First, we will take a detailed look at how index funds work. After that, we will take a look at the pros and cons of robo-advisors versus index funds, and which one of them is best for which kind of investor.
What Are Indexes?
In order to understand index funds, we first must understand indexes. A stock market index tracks select stocks by averaging them based on a formula. The output of the formula is a single number that can be used to track whether the stocks in the index went up or down as a whole. Usually, indexes are used to track markets of entire countries.
The most widely used index today for US stocks is the S&P 500. The S&P 500 includes 500 of the largest companies in the US, and those companies represent 70% of the total US stocks’ market capitalization. 70% is a large enough number for us to determine the market’s health simply from the S&P 500.
If you are interested in the math behind the indexes, you can take a look at this article on how to calculate the S&P 500. However, that is not important. What you should know is that a 1% increase in the S&P 500 usually means a 1% increase in the 500 stocks that it represents (on average).
How Index Funds Work
An index fund mirrors the performance of the index that it tracks. It does this by purchasing all of the stocks in the index according to their weight and holding them in perpetuity unless they are replaced by another stock in the index.
While it is possible for an individual investor to track an index themselves, the amount of effort required is not worth it. Not only will you need to purchase 500 individual stocks based on their weight, but you will also have to stay up to date with any changes made in the way the index is calculated.
Index funds are quite similar to robo-advisors. They are not managed by advisors, they have extremely low fees (typically less than 1%), and they offer considerable diversification across multiple industries. As such, a comparison between the two is necessary for a budding investor to decide what which suits their needs.
Why go For Index Funds?
By now, you should have a good idea of what index funds are. Let’s look at how they compare with robo-advisors.
Absence of Financial Advisors
We mentioned previously that financial advisors can have a detrimental effect on your investments (especially advisors that represent the small investor). Index funds are passively managed i.e. the firm managing the fund has no input over into the way they invest. As such, index funds avoid the pitfalls that active management can bring with it.
Index funds are usually very well diversified. This is because funds that target mainstream indexes (e.g. S&P 500 and the Dow Jones Industrial Average) are invested in companies across various industries. There is no correlation between many of these companies (which means that their prices do not move in tandem with one another since their businesses are different). This means that macro-economic factors that affect only one particular sector (e.g. tariffs on specific goods) will not have a huge effect on your investment.
Since risk is already well-managed in an index fund, you do not need active management. In fact, index funds perform better than the vast majority of managed funds over the long run.
Lower Fees
On the surface, it seems as if robo-advisors charge lower fees than index funds. Some robo-advisors even charge nothing for their portfolios. However, the actual cost of using a robo-advisor is actually higher than that of an index fund.
This is because a robo-advisor invests in various different funds. Many of these funds are actively managed, and hence they charge a fee for their services. While your robo-advisor may not charge any fee, it will still have to pay the management fee for all of the funds. In fact, some of the funds that your robo-advisor invests in may also take a percentage off of the profits that they generate.
An index fund, on the other hand, will not take a percentage of your profits and will only require a small amount for expenses. Almost all index funds available charge less than 1% of your total investment in fees. The vast majority of them lie somewhere between 0.5% to 0.75%. This means that if your robo-advisor and an index fund generate the same return, you will make more money with an index fund.
Index Funds Are Traditional Investment Vehicles
Another reason people prefer index funds over robo-advisors is that they are quite similar to other traditional investments. For people who are already utilizing a broker, investing in index funds is very easy. All you need to do is to instruct your account manager to purchase a specific index fund.
A robo-advisor, on the other hand, is a whole new innovation in the world of finance. As such, investing in a robo-advisor will require you to research the app yourself and make sure that it fits with your investing goals. People who are already investing through traditional channels should probably go for index funds as a result.
Why go For Robo-Advisors?
Index funds definitely possess a few inherent advantages over robo-advisors. However, robo-advisors are not a bad choice either. Here is why:
Robo-Advisors Might be Better During a Crash
We stated above that index funds are very well diversified. While that is true, index funds only invest in in a particular index. For example, a stock index-fund will only be invested in stocks (e.g. stocks in the S&P 500). This means that if the market crashes, then chances are that your fund will lose a large percentage of its value.
Robo-advisors, on the other hand, are invested in various different kinds of ETFs. Some of them invest in precious metals, while others invest in real estate. Obviously, any fund that trades on an exchange will lose some of its value during a market crash. However, these funds will ensure that you lose less than you would when investing in an index fund.
In fact, Michael Burry, one of the investors who predicted and profited from the 2008 financial crisis, says that the next market bubble may be caused by index funds themselves.
In the last couple of decades, more and more people have invested in index funds. As such, this has inflated price levels of the stock market according to Burry. This leads to prices that do not accurately reflect the intrinsic value of the underlying stocks. Burry is definitely as credible a source as you can expect when it comes to predicting market crashes, and his argument definitely makes sense.
Regardless of whether a crash is imminent or not, you can expect robo-advisors to perform better during a market crash (although it is not a guarantee).
Tax-loss Harvesting Gives Robo-Advisors an Edge
An index fund will always mirror the index that it represents. In fact, you do not own the stocks in the index fund. The fund owns them, and you own a portion of that fund. This means that you cannot change what you own in any way.
When it is the end of the year, it is possible to decrease the amount of tax you pay. You can do this by selling stocks that are doing poorly at a loss. Robo-advisors are perfect for this since they have something called tax-loss harvesting.
We have discussed tax-loss harvesting a fair bit in the previous articles. Simply put, your robo-advisor will automatically sell parts of your portfolio that are currently trading at a loss to decrease your tax liability. After that, the robo-advisor will automatically purchase assets that are similar in nature, saving you money in the process.
Robo-Advisors Are Customizable
Lastly, you cannot modify index funds according to your investment goals in any way. Robo-advisors allow you a fair amount of say in how you invest. Those who are looking to save for retirement will have different goals than those looking for maximum capital appreciation. A robo-advisor can take your needs into account when setting up a portfolio, but an index fund cannot.
Both Robo-Advisors And Index Funds Are Viable Long-Term Investments
So far, our deep dive into the world of passive investments has taught us the following:
- Both robo-advisors and index funds possess advantages over one another.
- Index funds are great for mixing with other traditional investments and possess lower fees.
- Robo-advisors are better protected against a market downturn and provide tax-loss harvesting.
- What you choose will depend on your investment goals.
Join me next time as I dive deeper into the world of robo-advisors. Specifically, I will take a look at tax-loss harvesting. Robo-advisors claim that it is the best way to make sure you pay as little a tax as possible. However, there are many dissenting views, and I will weigh them up to determine if there is any truth to them. If you need help with understanding how robo-advisors work, then contact me right now.
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