How do robo-advisors measure up against the long-standing benchmark of the ? The answer isn’t clear-cut, as it largely depends on an array of factors from market volatility to the investor’s specific financial goals and risk tolerance.
Over the past decade, robo-advisors have become an increasingly common way for everyday investors to get involved in the financial markets. Robo-advisors leverage algorithms to build optimized portfolios for their users, offering a low-cost, set-it-and-forget-it solution.
Key Takeaways
- Robo-advisors use algorithms to manage portfolios, making investing accessible to everyone.
- The performance of robo-advisors vs. the S&P 500 depends on a variety of factors, including market conditions and individual investment strategy.
- Both robo-advisors and the S&P 500 have their unique advantages and potential downsides.
- Choosing between a robo-advisor and investing directly in the S&P 500 comes down to personal financial goals, risk tolerance, and investment style.
Can Robo-Advisors Beat the Market?
The basic premise of a robo-advisor is straightforward: These digital platforms use algorithms to make investment decisions on behalf of users. After taking into account an investor’s financial goals, risk tolerance, and time horizon, the robo-advisor allocates their funds across a diverse range of assets, usually through low-cost index exchange-traded funds (index ETFs). These could include everything from stocks and bonds to real estate investment trusts and commodities. Once the initial allocation is made, the robo-advisor continually monitors the portfolio and rebalances it as necessary to maintain the desired asset mix.
Historically, professional investment management was a service accessible primarily to wealthy individuals or large institutions. However, robo-advisors have changed the game, offering the benefits of algorithmic investment management to everyone. This accessibility, coupled with lower fees than traditional human advisors, have made robo-advisors a popular choice among a new generation of investors.
But the question remains: Can robo-advisors beat the market? This will all depend. Robo-advisors construct well-diversified portfolios that follow the principles of Modern Portfolio Theory (MPT), which means that all portfolios, including aggressive ones, will have some allocations to broad-based U.S. stocks (e.g., via an ), as well as weights to other benchmarks and asset classes. An individual robo-advisor’s performance can also vary significantly depending on a variety of factors such as the effectiveness of their algorithms, the securities they use to construct their portfolios, and the range of asset classes that they draw from.
Factors That Affect Robo-Advisor Performance
One of the key factors that impact robo-advisor performance is the composition of the portfolios they manage. Unlike investing directly in the S&P 500, robo-advisors create diversified portfolios that include a range of asset classes, such as domestic and international equities, bonds, commodities, and real estate—which will vary depending on the investor’s risk tolerance, time horizon, and financial goals. This means that the performance of a robo-advised portfolio isn’t solely tied to the performance of the S&P 500 or any single market index. Instead, it reflects a blend of the returns from various asset classes, each with its own risk and reward profile.
For instance, on one hand, an investor with a high risk tolerance may have a portfolio with a larger allocation to equities, which have historically provided higher returns but also come with greater volatility. But this, too, would include more than just the S&P 500, with allocations to other indexes such as the small-cap Russell 2000 or the tech-heavy Nasdaq 100.
On the other hand, a more risk-averse investor might have a more significant portion of their portfolio in bonds, which typically offer more stable returns. The composition of the portfolio will significantly impact the performance of a robo-advised investment.
Another factor that can influence robo-advisor performance is the specific exchange-traded funds (ETFs) that they use to build their portfolios. Even ETFs that track the same benchmark can have different levels of tracking error, which is the divergence between the ETF’s performance and the performance of the benchmark that it’s supposed to track. The amount of tracking error can be influenced by a variety of factors, such as the ETF’s expense ratio, its method of replicating the benchmark, and the liquidity of the securities it holds. Therefore, the choice of ETFs by the robo-advisor can impact the overall portfolio performance.
Another consideration is the rebalancing strategy employed by the robo-advisor that also has a bearing on its performance. Rebalancing is the process of realigning the weightings of a portfolio’s assets to maintain the desired levels of risk and return. By regularly rebalancing, robo-advisors ensure the portfolio doesn’t drift too far from its target allocation due to the differing performances of various assets. However, the frequency and method of rebalancing can impact transaction costs and tax efficiency, which in turn affect the net return of the investment.
Factors That Affect the S&P 500’s Performance
The S&P 500, or Standard & Poor’s 500, is a popular stock market index that serves as one of the primary benchmarks for the U.S. stock market. It tracks the performance of 500 large-cap companies listed on stock exchanges in the United States. The index is widely regarded as the best single gauge of large-cap U.S. equities and a reliable indicator of the health of the nation’s economy. The S&P 500 includes firms from all sectors of the economy, making it a representative snapshot of the overall U.S. stock market.
The composition of the S&P 500 is not arbitrary. It’s constructed and regularly updated by a committee at , a provider of indexes and credit ratings. Companies are selected based on specific eligibility criteria, including market capitalization, liquidity, domicile, financial viability, and length of time as a publicly traded stock.
Importantly, the S&P 500 is a market-capitalization-weighted index, which means that larger companies account for a greater portion of the index. Therefore, the performance of the largest companies will have a more significant impact on the performance of the S&P 500 as a whole.
Macroeconomic conditions, such as the health of the economy, inflation rates, and monetary policy, can also drive broad-based market trends that impact all companies in the index. Corporate earnings also play a crucial role, as strong earnings can boost stock prices, while weak earnings can drag them down. Additionally, geopolitical events, changes in consumer behavior, technological advancements, and other sector-specific trends can influence the performance of individual companies and, consequently, the overall performance of the S&P 500.
Robo-Advisor vs. S&P 500
Comparing robo-advisors to the S&P 500 isn’t an apples-to-apples comparison. While the S&P 500 is a broad market index, robo-advisors are tools that can invest in a broad range of assets, often including an allocation to S&P 500 index funds. Each has its unique advantages and potential downsides, and the choice between the two should be based on your individual investment goals and risk tolerance.
Investing directly in the S&P 500, through an index fund or an ETF, has its merits. It offers a straightforward and low-cost way to gain exposure to much of the U.S. stock market’s growth potential. However, investing solely in the S&P 500 also means that your portfolio is not diversified beyond the scope of large-cap U.S. stocks, which can expose you to certain risks that greater diversification can help mitigate.
The best robo-advisors offer some unique advantages over investing solely in the S&P 500:
- They typically provide a level of diversification that you wouldn’t get from investing in any single index. By spreading investments across various asset classes, robo-advisors can help reduce risk and potentially smooth out returns over time.
- They automate many aspects of the investment process, such as portfolio rebalancing and tax-loss harvesting, which can benefit investors who prefer a more hands-off approach.
However, it’s worth noting that robo-advisors do come with management fees, which, although quite modest, can eat into your returns over time.
Do Robo-Advisors Beat the S&P 500?
This will vary significantly depending on the risk profile of the portfolio, broader market conditions, and the specific robo-advisor used. Some robo-advisor portfolios may outperform the S&P 500 in certain years or under specific conditions, while in others, they underperform.
Is the S&P 500 Better than a Financial Advisor?
This question is a bit like apples and oranges. If your sole goal is to invest in the U.S. stock market, investing in a low-cost fund that tracks the S&P 500 could be a good choice. However, if you need comprehensive financial advice and guidance, a financial advisor could be worth the additional cost.
In many cases, it’s not a matter of choosing between the S&P 500 and a financial advisor, as a financial advisor may recommend investing in the S&P 500 as part of a broader investment strategy.
Should I Use a Robo-Advisor for an Index Fund?
Robo-advisors can be an efficient and hassle-free way to invest in a diversified range of index-following options. Still, it’s also important to consider the strategies and fees associated with these services.
What Is a Disadvantage of Using a Robo-Advisor?
While robo-advisors offer a convenient, low-cost, hands-off approach to investing, they often lack the flexibility and autonomy of self-directed investing, and the personalized advice and human touch that a traditional financial advisor can provide.
The Bottom Line
Choosing between a robo-advisor and the S&P 500, or any other investment, is not a one-size-fits-all decision. It’s about finding the right fit for your financial goals, risk tolerance, and investment style.
While an S&P 500 index fund or ETF will provide low-cost exposure to the broader U.S. stock market, it also limits the scope of your holdings to just large-cap U.S. stocks. A robo-advisor, on the other hand, will often provide a range of asset classes (each represented by an index ETF), which may very likely include a weighting to the S&P 500 itself.
