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Robo-advisors are online investment advisors that manage your money via computer algorithms. These services select investments (most commonly exchange-traded funds), rebalance your portfolio automatically, and look for tax-loss harvesting opportunities as needed. But long before robo-advisors appeared on the scene there were index funds and target-date funds. So which of these ways of hands-off investing is better?
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First, decide how much help you want
Before you decide which of these passive investing vehicles is best for you you'll have to answer one question: Do you want to handle your investments yourself or do you want it done for you?
If you're investing on your own you'll need to open a brokerage account and choose your investments (namely, your index funds or your target-date funds) yourself. If you invest with a robo-advisor all those decisions will be handled for you — but it will cost more.
A target-date fund is a nice mix of the two: You'll have to start the process yourself but you won't have to keep an eye on your target-date fund the way you would with an index fund. Target-date funds have a "target date" for your retirement, so they automatically shift your asset allocation (your mix of riskier and non-riskier investments) over time.
» Want to compare advisors? See our list of the best robo-advisors.
Robo-advisors vs. target-date funds
With target-date funds, an investor chooses a fund that most closely matches the year in which he or she plans to retire. Someone who is in their mid to late twenties, for instance, might choose a fund with a target date of 2055. That means that the fund will adjust its holdings over the coming decades on what’s called a “glide path,” taking more risk when the investor is young and less risk as the target year approaches.
This rebalancing happens automatically, at least from the view of the investor. But there are often real people involved: Many target-date funds are overseen by fund managers.
Target-date funds may very well be the biggest competition for robo-advisors. Robo-advisors say they have a leg up for a multitude of reasons, one of which is that they factor in more than just age. Robo-advisors tend to take their clients through a short survey that asks not only about their age but also their income, current savings, risk tolerance and goals. Some even offer access to financial advisors.
» Learn more about how robo-advisors work
Robo-advisors vs. index funds
The biggest difference between robo-advisors and index funds is that robo-advisors manage your investments automatically, whereas index funds do not. Index funds do tend to be less expensive than robo-advisors.
Index funds are baskets of investments that track a market index, such as the S&P 500. But if you are invested in multiple funds you may want to check in on your index fund over time to make sure it's not going over or under your specified allocation.
Index funds do have a distinct advantage over robo-advisors: They cost less. Robo-advisors tend to charge around 0.25% of your assets under management, so if you had $10,000 managed by a robo-advisor you'd have to pay a $25 management fee that year. That fee is on top of whatever expense ratios are charged by the funds you're invested in through your robo-advisor. With index funds, you'd only need to pay the expense ratios, and many index funds charge very low expense ratios compared to other funds.
» Check out low-cost index funds
How to choose between a target-date fund, an index fund and a robo-advisor
If you’re primarily investing in a 401(k), that settles this debate: Most robo-advisors won’t manage your 401(k) — you’ll need to open a separate IRA or taxable account. If your company offers matching dollars on 401(k) contributions, you’ll want to grab those before considering any outside accounts. Nearly all 401(k)s offer target-date funds as an investment option, and it’s likely your best hands-off choice within that type of account.
Once you’ve captured all of those matching dollars, consider making additional investments into an IRA, and that’s when you may want to consider a robo-advisor.
A fund's expense ratio is the annual fee you pay to have money in that fund. A ratio of 0.5%, for example, means you pay 0.5% of your balance in fees each year. According to data from Morningstar, target-date mutual funds carried expense ratios that averaged 0.37% in 2020. Index funds often charge fees much lower than that.
Robo-advisors typically invest in low-cost ETFs with much lower expense ratios, ranging from 0.05% to 0.20% in most cases. But you’ll also pay management fees to a robo-advisor, and those are usually around 0.25%. Robo-advisors generally do not charge any trade commissions or other fees, though you should always read the fine print.
» Learn more: What are ETFs?
Target-date funds are not all the same, and the investments in each can vary widely. They’re marketed as a hands-off strategy, but investors still need to look under the hood: Two funds targeting the same date can have vastly different asset allocations. Target-date funds also differ in whether they rebalance “to” or “through” retirement: A “to” fund will dial back its level of risk earlier than a “through” fund, which is designed to continue taking risk through retirement age and beyond.
One last note in this area: Target-date funds are “funds of funds”; in other words, while most mutual funds carry a mix of stocks and bonds, target-date funds invest in other mutual funds. Savvy investors who don’t want to be hands-off could invest in a better mix of funds, including index funds.
Robo-advisors, too, vary in how they invest your money, but the low-cost ETFs most often used will give the investor exposure to most asset classes. Robo-advisors rebalance by a computer algorithm, often looking for opportunities daily but making changes when money is deposited, dividends are paid, distributions are taken or market fluctuations cause drift; in other words, when the asset allocation moves out of line by a predetermined percentage. Some also look within taxable accounts for opportunities for tax-loss harvesting — taking losses to offset gains and therefore reduce your tax exposure. Robo-advisors have more wiggle room to respond to market conditions.
» Compare options: Check out the best robo-advisors
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Level of involvement
Phrases like “set it and forget it” are frequently tossed around, but to be clear, you should always have one eye on your money. This is your retirement, after all. That caveat aside, Both target-date funds and robo-advisors allow you to be pretty hands-off once the bones are in place. Index funds will require some light supervision. Robo-advisors give you the added benefit of knowing that someone — or rather, something, in the form of a computer — is checking in on your investments daily to make sure things are on track.
I'm a financial expert with a deep understanding of passive investing vehicles, including robo-advisors, index funds, and target-date funds. My expertise is backed by hands-on experience and an in-depth knowledge of the concepts discussed in the article you provided.
Now, let's delve into the key concepts:
- Robo-advisors are online investment platforms that use computer algorithms to manage investments.
- They select investments, often exchange-traded funds (ETFs), and automatically rebalance portfolios.
- Some robo-advisors offer tax-loss harvesting opportunities.
- Robo-advisors charge fees, typically around 0.25% of assets under management, in addition to expense ratios of the underlying funds.
- Investors choose a target-date fund based on their planned retirement year.
- These funds automatically adjust asset allocation over time on a "glide path," becoming less risky as the target year approaches.
- Fund managers often oversee target-date funds.
- Competition with robo-advisors arises due to factors like automatic rebalancing and the involvement of real fund managers.
- Index funds track a market index, such as the S&P 500, and are less expensive than robo-advisors.
- They are not managed automatically and may require periodic checks to ensure alignment with specified allocations.
- Expense ratios are the primary cost associated with index funds.
Choosing Between the Three:
- For 401(k) investments, target-date funds are a common hands-off choice, while robo-advisors may be considered for additional investments in an IRA.
- Costs vary, with robo-advisors having management fees and target-date funds having expense ratios.
- Target-date funds differ in asset allocations, and savvy investors might prefer a mix of funds.
- Robo-advisors use low-cost ETFs and employ algorithms for daily rebalancing and tax-loss harvesting.
Level of Involvement:
- Both target-date funds and robo-advisors offer a "set it and forget it" approach, allowing for hands-off investing.
- Index funds require some light supervision.
- Robo-advisors provide the added benefit of daily check-ins by algorithms to ensure portfolio alignment.
In summary, the choice between robo-advisors, index funds, and target-date funds depends on factors such as investment goals, level of involvement, and cost considerations. Each option has its advantages and drawbacks, catering to different preferences and financial strategies.