Robo-Advisor

SEC staff describe robo-advisers as firms, typically registered investment advisers, that use online algorithm-based programs to manage clients’ money with discretion. You answer a questionnaire about your goal, timeline, income, other assets and risk tolerance. The service matches your answers to one of its model portfolios, often a mix of broad ETFs across US stocks, international stocks and bonds, and invests your money in an account held at a brokerage.

After that, the software runs the account. It invests new deposits, reinvests dividends and rebalances when the mix drifts from its target. Some services add tax-loss harvesting in taxable accounts, goal tracking and automatic deposits.

The amount of human help varies widely. Some services offer only technical support, while hybrid services, which the SEC’s investor education staff has called “bionic” advice, let you contact an investment professional, sometimes only above a minimum account size. The SEC also warns that a robo-adviser’s recommendation is limited by the information it asks for, and some never ask about your debts, home or other accounts.

A robo-advisor’s price has two layers. The first is the advisory fee, often a percentage of the assets it manages, deducted from the account; see AUM fee. The second is the expense ratio of each fund in your portfolio, which you pay inside the funds and never see on a bill. The SEC points out that low-cost advice paired with high-cost funds can still add up to a high total, so add both layers, as in the formula below.

Ask how else the firm is paid. The SEC suggests checking whether a robo-adviser offers only products from affiliated fund companies, is paid to recommend particular products, charges to withdraw, transfer or close an account, or pays others for client referrals.

Then compare the total with simpler alternatives. The SEC’s bulletin notes that a robo service may not differ much from what you could get from a traditional advisory program or a single target-date fund, which charges fund expenses but no separate advisory fee.

Many robo-advisors offer automated tax-loss harvesting in taxable accounts. When a fund falls below what you paid, the software sells it and buys a similar, but not substantially identical, fund, so you stay invested while realizing a capital loss that can offset gains and up to $3,000 a year of other income ($1,500 if married filing separately).

The trouble is what the software cannot see. Under the wash-sale rule, a loss is disallowed if substantially identical securities are bought within 30 days before or after the sale, and IRS Publication 550 says that includes purchases for your own IRA or Roth IRA and purchases by your spouse. A robo-advisor that never asks about those accounts will not notice a dividend reinvested in your IRA elsewhere, or a spouse’s automatic purchase. If the repurchase happens inside an IRA, Revenue Ruling 2008-5 says the disallowed loss does not increase your basis in the IRA, so the loss is lost rather than postponed.

Even a clean harvest mostly defers tax. Each loss lowers your cost basis and enlarges a later gain, unless you hold the shares until death and your heirs receive a stepped-up basis.

The two differ mainly in scope. A robo-advisor manages an investment portfolio. A human financial advisor can also coordinate the decisions around it: when to claim Social Security, which accounts to draw first in retirement, whether to convert to a Roth, how much insurance to carry and how to leave money to heirs. Those choices can matter more than a few tenths of a percent in fees.

Both can be held to a high standard. SEC staff guidance says robo-advisers, like all registered investment advisers, are subject to the substantive and Fiduciary obligations of the Investment Advisers Act of 1940. The same guidance warns robo-advisers not to imply that they provide a comprehensive financial plan when they do not consider a client’s taxes or debts, or that a tax-loss harvesting service amounts to comprehensive tax advice.

Someone early in a career with a simple situation may need little beyond automated investing. Someone near retirement with several account types, a pension or stock compensation may get more from planning advice, from a person or a hybrid service.

Because there may be no conversation with a person before you invest, the firm’s documents do the explaining. Every registered investment adviser files Form ADV, and its Part 2 brochure describes services, fees and conflicts of interest. SEC-registered advisers and brokers must also give retail investors a short relationship summary called Form CRS. You can find both, along with the firm’s registration and any disciplinary history, through the investment professional search on Investor.gov. Then work through these questions.