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Robo-advisers are the hottest trend in investing, but for most there’s a better way

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One of the hottest trends in the retail investment advising world is robo-advisers. These are online sites — two of the most popular are Wealthfront and Betterment — that allow people to manage their investment portfolios with a website.

The companies' marketing pitches are simple: They perform the same task as a conventional investment adviser, but charge a fraction of the cost. Conventional investment companies have fees as high as 1 percent of a customer's invested assets. Betterment and Wealthfront cost about a third as much.

It's true that if you're paying someone a 1 percent fee to manage your money, you should stop doing that. But it's not true that Betterment and Wealthfront are the best alternative. A class of mutual funds called target date funds cost about half as much as robo-advisers, while providing a very similar service.

Betterment and Wealthfront offer tax-related services that may be useful to customers rich enough to exceed the $23,500 annual limit on tax-free savings. But if you're not that rich, you'll probably be better off saving money with an old-fashioned target date fund.

Most people don't actually need an investment adviser

Saving for retirement isn't complicated. You can click here for the full Vox retirement guide, but fundamentally there are three things you need to do to get the most out of your retirement savings:

  • Invest in low-fee index funds.
  • As you get older, shift your investments from riskier stocks to safer bonds.
  • Don't sell until you reach retirement age, even if markets crash.

A financial product called a target retirement fund makes this really easy. You choose the fund that corresponds to your expected retirement date (for example, I'm in my mid-30s so I would choose Vanguard's Target Retirement 2045 fund), and the fund does the rest, gradually shifting to safer assets as you get closer to your retirement date.

There are low-cost target retirement funds available from Vanguard, Fidelity, and State Street. Signing up only takes an hour or two, and once you've deposited your cash with one of these companies, you shouldn't have to think about it again until you reach retirement age.

Robo-advisers are only cheap compared to unnecessary human advisers

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The development of these target date mutual funds is great news for consumers, but it leaves professional investment advisers — at least those that serve non-wealthy clients — with little to do. But instead of admitting that they'd been rendered obsolete and shutting down, investment advising companies have built elaborate marketing machines designed to obscure the fact that most people don't need professional advice about where to invest their retirement savings.

The marketing has been pretty effective, so a lot of people pay human advisers a lot of money — an annual fee of 1 percent of invested funds isn't uncommon — for advice that they don't really need.

That has created a big opening for a new generation of companies called robo-advisers. Their pitch is that they'll provide the same basic service as a human investment adviser for about a third the cost. They're called robo-advisers because they provide "advice" using an automated website instead of having you talk to a human investment adviser.

Robo-advisers mostly perform the same functions as a target retirement fund. As markets fluctuate, they automatically rebalance your portfolio to maintain an optimal mix of stocks, bonds, and other assets. And as you get closer to retirement age, robo-advising companies shift more money into the safest investment categories, reducing the risk that a stock market crash will devastate your finances right before you reach retirement age.

To the extent that robo-advising companies are stealing customers away from overpriced investment advisers, that's a great development for consumers. The exact fees Wealthfront and Betterment charge depend on how much money you invest with them, but most investors will pay annual costs and fees between 0.25 percent and 0.37 percent. That compares favorably with conventional advisory services that can charge as much as 1 percent.

On the other hand, Betterment and Wealthfront's fees don't compare favorably to the best target date funds. Vanguard, Fidelity, and State Street all offer target date funds with expense ratios between 0.13 and 0.16 percent — about half what typical customer will pay for service from Wealthfront or Betterment. (It's important to note that not all target date funds are this cheap — most others cost significantly more, so always check a fund's expense ratio before you invest.)

Robo-advisers don't provide much more value than a target date fund

To their credit, Wealthfront and Betterment are pretty candid about the similarities between their products and target date funds. Wealthfront addresses the issue explicitly on its website, writing that "we believe the next best option to having your portfolio managed by Wealthfront is investing in Vanguard’s target date funds."

Wealthfront points to two big reasons its products are better than a target date fund. One is tax efficiency. Wealthfront offers a service called tax loss harvesting that helps investors claim tax deductions when their investments lose value. Wealthfront claims that the tax savings from using the service can add as much as 1 percent annually to investment returns.

Unfortunately, Wealthfront's methodology doesn't stand up to scrutiny — the average investor isn't going to get anywhere close to 1 percent gains from this feature. Also, there are some legal risks to automating a complex tax-avoidance process.

But more to the point, you have to be pretty rich for this feature to be useful. Tax loss harvesting only becomes useful after you max out tax-advantaged accounts like 401(k)s and IRAs. The legal limits on these accounts are $18,000 for a 401(k) and $5,500 for an IRA (note that there are also some income-related limits for both Roth and traditional IRAs). Unless you're in the small minority of workers saving more than $23,500 per year ($47,000 per year for a couple), tax loss harvesting is totally irrelevant.

Wealthfront also argues that its service is better at fine-tuning a customer's portfolio — the same argument Betterment's CEO made when I talked to him in 2012. Target date funds are relatively crude, using exactly the same portfolio for everyone planning to retire within a particularly five-year window. As a result, Wealthfront argues, "the return on the target date fund might be too high or too low for a particular buyer’s risk tolerance."

Yet it's not obvious how much value this adds in practice. Most savers — even fairly sophisticated ones — don't know how to precisely quantify their "risk tolerance." They know they want to maximize their long-term returns without taking on too much risk, but beyond that it's mostly guesswork.

And if you want more or less risk than your target date fund offers, there's a simple way to do it without paying robo-advisers' higher fees: use a target date fund for a different year than your actual retirement year. Suppose, like me, you expect to retire around 2045. If you want to take a bit more risk, you can invest in Vanguard's Target Date 2050 fund, which will keep your money in high-risk, high-reward stocks for five years longer than the Vanguard's 2045 portfolio. Conversely, if you want to play it safe you can invest in the Target Date 2040 fund, which will start shifting to safer assets five years earlier.

At root, robo-advisers' argument against target date funds is that they're out of date. Betterment emphasizes that the funds were invented more than 20 years ago and haven't changed much since then. But the fact that something is old doesn't mean it's bad. And robo-advisers just don't seem to offer much value to justify their higher costs.

Disclosure: I have most of my retirement savings in Vanguard mutual funds, and because Vanguard is structured as a cooperative, that technically makes me a Vanguard shareholder.

Correction: I originally described Betterment and Wealthfront as the two most popular robo-advisors, but Scwab's Intelligent Portfolio product is more popular than either.