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Robo-advisors and index funds are trending options for investors looking to grow their wealth over time. But which one is better? Choosing between a robo-advisor and an index fund depends on your investment goals, risk tolerance and personal finance levels.
This guide to robo-advisor vs. index funds will comprehensively compare the two options and help you choose which one best meets your needs.
What is a Robo-Advisor?
A robo-advisor is an automated financial advisor that uses computer algorithms to offer personalized financial advice and manage investment portfolios.
The process typically starts with a questionnaire to assess the client’s risk tolerance, investment goals and time horizon.
Based on the answers, the robo-advisor will recommend a diversified portfolio of low-cost exchange-traded funds (ETFs) that aligns with the clients’ robo-advisor accounts.
The portfolio is then automatically rebalanced to maintain the target asset allocation.
Example of a Robo-Advisor
An example of a robo-advisor is Betterment, an online investment management platform that offers a variety of investment options — including ETFs and individual stocks — and provides tools and resources to help users make informed investment decisions.
According to Bloomberg, Betterment and Vanguard were the best robo-advisors in 2023, with the Betterment robo-advisor 90 Portfolio generating a compound annual return of 8.43% over the past 30 years.
Advantages of Using a Robo-advisor
Here are the benefits of using a robo-advisor.
- Low fees: Robo-advisors have lower fees than traditional financial advisors because they use algorithms and automation to manage portfolios, which reduces the need for human labor and overhead costs.
- Automated Rebalancing: Robo-advisors use algorithms to monitor and adjust a portfolio to maintain the desired asset allocation and ensure the portfolio stays in line with the investor’s risk tolerance and investment goals.
- Low minimum investment: Robo-advisors have a low minimum investment requirement that allows individuals with limited funds to start investing and growing their wealth.
- Available 24/7: Robo-advisors are available 24/7, so you can access your investment account and make trades at any time — you are not limited to a traditional financial advisor’s hours of operation.
- Efficient: Robo-advisors use algorithms and automation for portfolio management and investment decisions, saving time and reducing the potential for human error.
- Tax-loss harvesting: Robo-advisors use tax-loss harvesting to help their clients minimize their tax liability by automatically identifying and selling losing positions in a portfolio and then replacing them with similar investments.
- Diversification: Robo-advisors use algorithms to create and manage a diversified investment portfolio for their clients, which helps spread risk across various asset classes and investment options, thus reducing the impact of any one investment on the overall portfolio.
Drawbacks of Robo-Advisors
Let’s look at some of the disadvantages of robo-advisors.
- Limited flexibility: Robo-advisors have limited flexibility regarding the types of investments they offer and the level of customization available to users. This makes it difficult for investors with specific investment goals or risk tolerance levels to find a robo-advisor that meets their needs.
- Limited human interaction: While robo-advisors can provide automated investment advice, they may not be able to offer the same level of personalized guidance and support as a human financial advisor.
- No personalization: Robo-advisors use algorithms to create portfolios based on rules and historical data, which may not consider an individual’s unique financial situation, goals and risk tolerance.
What are Index Funds?
An index fund is an ETF fund that financiers construct to match a financial market index. Index mutual funds have the benefit of providing broad market exposure and have low operating expenses and low portfolio turnover.
These funds follow their benchmark, regardless of the state of the financial markets. As a passive investment, they do not try to outperform the market, but aim to replicate its performance.
Example of an Index Fund
Vanguard 500 Index Fund Admiral Shares (VFIAX) is an example of an index fund. It is a type of mutual fund or ETF that aims to track the performance of a specific market index, such as the S&P 500.
The fund holds a diverse portfolio of stocks, representing the performance of the S&P 500 Index. It’s a low-cost, broad-based way to invest in the U.S. stock market, which you can analyze using Nasdaq.
Past performance based on 10 years shows that the fund has generated a 13.30% return, which makes it a solid future investment for many.
Benefits of an Index Fund
Here are the advantages of an index fund.
- Low fees: Index funds have lower fees than actively managed funds because they simply track the performance of a market index rather than trying to beat it through stock picking and market timing.
- Broader diversification: Investors gain exposure to a wide range of companies by investing in an index fund and reducing their overall risk. No single stock can significantly affect the fund’s overall performance.
- Lower taxes: Index funds result in lower taxes than actively managed funds because they generally have a lower turnover of their portfolio holdings, meaning there is less capital gains realization, and fewer taxes get owed.
- Attractive returns: An index fund provides attractive market returns over the long term because it aims to mirror the performance of the underlying index, composed of a diverse group of stocks or bonds.
- Passive investing: A benefit of using an index fund to implement a passive investing strategy is that it allows investors to gain broad market exposure at a low cost. Index funds have lower expense ratios than actively managed funds.
Drawbacks of Index Funds
Let’s look at the cons of index funds.
- No control over holdings: The fund tracks a particular index, and the composition of that index determines the holdings. Investors have no say in company inclusion in the fund or asset allocation.
- No downside protection: Index funds do not provide downside protection. If the market declines, the value of an index fund will also decrease.
- Underperformance: Index funds may deficit actively managed funds or a benchmark index. This happens if the index the fund is tracking underperforms the market or the fund’s expenses are higher than those of other funds.
- Highest investment minimums: Index funds often have higher investment minimums than other funds, making it more difficult for small investors to get started.
Robo-advisor vs. Index Funds: How do they compare?
Robo-advisors and index funds are investment options with crucial similarities and differences. Let’s compare and contrast index funds and robo-advisors.
|Computer selects investments||No tax strategies|
|Automatic contributions||Managed portfolios|
|Automatic rebalancing||Higher minimums|
|Tax-loss harvesting||Broad market exposure|
|Low minimums||Passively track an index|
Robo-advisors and index funds use portfolio rebalancing to maintain a specific asset allocation within the portfolio. Both options provide a low-cost way to invest and can be a good choice for long-term investors.
Robo-advisors and index funds also both employ a passive investment strategy. They aim to track the performance of a specific market index rather than trying to beat it through active management.
Additionally, robo-advisors and index funds have lower management fees than actively managed funds.
Should I Use a Robo-Advisor or Index Fund?
The winner of the robo-advisor vs. index fund debate depends on your personal financial goals and risk tolerance. Robo-advisors are typically less expensive than traditional financial advisors and can be a good option for those who want to invest with minimal effort.
Index funds are also generally low cost and can be a good option for those who want to diversify their portfolio without actively managing it. Talk with a financial advisor to find out which is best for you.
- You want a low-cost, automated investment management option.
- You want to diversify your own portfolio with a wide range of assets.
- You want access to professional investment management without the high fees associated with traditional human financial advisors.
- You want a low-cost, diversified investment option.
- You want to track the performance of a stock market index, such as the S&P 500.
- You want a passive investment strategy instead of actively picking and trading individual stocks.
Here are frequently asked questions regarding robo-advisors vs. index funds.
Do robo-advisors invest in index funds?
Many robo-advisors develop your portfolio using affordable ETFs instead of individual stocks or mutual funds. They may use an index fund or a passive investment strategy.
Are robo-advisors better than the S&P 500?
No. Compared to the S&P 500 index, robo-advisors do not outperform the market.
Are index funds good for beginners?
Index funds are a good option for first-time investors because they are a simple, low-cost way to invest in a diversified portfolio.