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Here's Why Even the Best Robo-Advisor May Disappoint You - Outside View by PersonalFN

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Here's Why Even the Best Robo-Advisor May Disappoint You
Apr 6, 2017

  • "The Only Thing Constant Is Change" - Heraclitus (a Greek philosopher)

While we live in a dynamic world, everything around us is bound to change gradually. Not only the way we look at things, but also the way we do different tasks, including investments. The way we invest and the way we receive advice.

Over the past couple of years, a new form of investment advisory has emerged a new class of advisors known as robo-advisors. These online platforms use technology that runs complex algorithms to develop automated customised portfolio allocation and investment recommendations. Robo-advisors are able to attract clients with their attractive low costs. Some even claim it to be a free service or virtually free.

But is it?

You need to look deeper before you zero in on the best robo-advisory platform that may seem economical for you.

Let's face it... there are no free lunches in life. Businesses are established to earn money and generate profits. Look deeper before zeroing in on the best robo-advisory platform that may seem economical for you.

  • An advisory or subscription fee (monthly, quarterly or yearly)

  • A transaction fee (each time you execute a transaction through them, they charge you a fee)

  • A percentage of the amount invested. (Popular in the US)

  • Commissions earned from fund houses of recommended funds

While the first three forms are upfront one-time costs, watch out for the last option.You can always decide whether the subscription fee or transaction fee is worth your money depending on the quality of advice and services offered. Also, if you have a high quantum of assets, you can avoid investing with robo-advisors that charge you a percentage of your investment value. The costs may end up higher than the one-time fees you would pay otherwise.

However, if your robo-advisor claims to offer you the service for free, then beware!

Maybe the advisory is pocketing huge commissions from the funds they recommend. And you may be surprised to know that the same is being deducted from the value of funds in your portfolio, in the form of high expense ratio. Yes the regular plans recommended by most of the robo-advisors come with high expense ratio, due to which you might be losing a significant amount of money every year.

If your robo-advisor does not offer you direct plans, Over the years, you will be losing out on generating significant wealth for yourself. How? Read ahead.

Direct plans of mutual fund schemes charge a lower daily fee (better known as expense ratio) as they eliminate distribution costs and commission paid to the distributor. These plans are thereby able to generate a higher return over the long-term and save investors a huge amount of cost. Both the plans have the same underlying portfolio, fund manager, and follow the same investment strategy, but different expense ratio and NAVs. While 'regular plan' charges you a high expense ratio, a lower expense ratio for a 'direct plan', enables you to clock better returns than the regular plan.

For example, if the underlying portfolio earns 14% (annually) pre-costs, the direct plan would earn returns of 12% post-costs, while the regular plan will garner returns of 11% after deducting the fees. Here, we have assumed an expense ratio of 2% for direct plans and 3% for regular plans.

Why should you prefer direct plans?

Mutual fund direct plans make a positive difference to your investments every year. These plans generate roughly 0.5% to 1.0% additional returns every year, thanks to lower costs. It may not seem much at first, but, if you sow seeds of these small savings, you may harvest rich rewards over 15- 20 years - thanks to the power of compounding.

Save Huge Costs Over The Long Term

As can be seen in the chart above, a small difference in costs can result in savings of anywhere between Rs8-17 lakh over 20 years, on a Rs10 lakh investment. Yes, you can earn an additional amount of as much as Rs17 lakh, if the difference in costs is as much as 1% point. The final portfolio value varies with the magnitude difference in expenses. Every 0.25%-point difference in the expense ratio works out to an additional earning of Rs4.50 lakh in 20 years' time, if Rs10 lakh is invested.

This Rs10 lakh investment is just as assumption. In reality, if you are saving for your long-term goals such as retirement. you will be targeting a corpus of over Rs1 crore for sure. Just imagine the costs then. Surely, you do not want to lose your hard-earned money in the form of costs that can be easily avoided. Moreover, the additional saving to such an extent can make huge difference to your financial goals.So, if you are compromising on long-term returns by availing the services of so-called free robo-advisors, it's high time to look for transparent alternatives before it's too late.If you are looking for the best mutual fund to invest in, then 'FundSelect' is something you should try right away.

Want to know more about robo-advisors, continue reading here:

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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