What is a Robo Advisor?

Introduction:

Think about how technology has made our lives easier. Everything is just a click away, from booking tickets to planning a trip, shopping, or making payments. Now, imagine if you could have the same convenience in managing your investments. That’s what a robo-advisor does. It’s like having a personal financial advisor but without the hassle of making numerous calls, fixing appointments, or doing extensive research. With the increasing popularity of AI platforms like the rise of ChatGPT, robo-advisors have captured a significant share of the investment market. What exactly do financial advisors help with? And are these suitable for all? Let’s find out. 

What is a robo advisor?

A robo-advisor is a digital investment service platform that manages your portfolio and provides financial advice using advanced algorithms. These algorithms, powered by artificial intelligence (AI), offer financial advisory services with minimal human intervention, including equity asset management. Most robo-advisors use rule-based logic and are expert systems designed for financial services, particularly investment and portfolio management. They may not be physical robots, but they function similarly, and you can interact with them through smartphone apps or the web. 

If you are a new user, the robo-advisors will begin by having you complete a short questionnaire. The questionnaire asks for your age, risk tolerance, retirement timeline, and reactions to market fluctuations. These details help determine your portfolio’s asset allocation, usually a mix of stocks, bonds, and uninvested cash that earns a fixed return. So, based on the answers, they automatically select suitable investments using an algorithm. 

After setting up, the robo-advisor manages your investments with periodic adjustments. The entire process is automatic, requiring little to no action from you. The robo-advisors charge either a percentage of the AUM plus other necessary charges or a flat fee, including fixed charges per transaction. However, some of the robo-advisors offer free services to a limited extent. 

Working models of robo-advisors:

The working models of robo-financial advisors generally fall into three categories.

1. The first type follows an advisory model, charging an advisory fee. These platforms let you invest in mutual funds, often with convenience fees. The direct plans on such platforms save on distributor commissions but usually come with advisory or transaction fees.
2. The second type operates on a distribution model, similar to traditional advisors. These platforms give you free advice on funds and assets and complete the transactions through the platform. In return, they charge a commission from the mutual fund house, not from you. However, the robot-advisors’ free service in this model is only available when you invest in regular plans. For direct plans, you must complete the investment independently. 
3. The third type follows a mixed model. They charge you for advice but allow independent transactions. For example, Arthayantra charges Rs.1,000 annually for financial advice, but if you invest through their platform, the service fee is waived, and they earn a commission from the fund house.

How does a robo-advisor help?

1. Portfolio Management:

Robo-advisors curate optimal portfolios based on your preferences. They generally use the Modern Portfolio Theory, which emphasises allocating funds to stocks that are not perfectly correlated. They diversify your portfolio and allocate funds between risky and risk-free assets, determining weights based on your financial goals and risk profile. They also monitor and adjust the portfolio as economic conditions change, rebalancing the weights of these assets.

2. Tax-Loss Harvesting

Tax-loss harvesting is a method to offset the capital loss made from the sale of one equity with the profit gained from another equity to reduce the total tax liability of the financial year. However, investing in a similar security is necessary to maintain portfolio allocation and benefit from market upturns. Robo-advisors automate this process, making tax-loss harvesting effortless. For instance, if the SBI NIFTY 50 ETF loses value, the robo-advisor will sell it to lock in a capital loss and buy a different ETF simultaneously to keep the portfolio balanced.

3. Rebalancing Bands:

The robo-advisor will assign rebalancing bands to each asset class or individual security. This defines the target weight and tolerance range for the asset. For instance, your portfolio holds 35% in emerging market equity, 35% in government bonds and 30% in blue chip stocks. Say you have kept a 2% corridor for each, meaning an asset class allocation can go 2% up or down. So, if blue chip stocks make up 32% of the portfolio, it is fine; if it becomes 35%, the robo-advisor will rebalance the portfolio to match the initial target composition.

Robo-advisors started as a portfolio allocation software in the early 2000s in the USA and, with time, have taken root in the Indian market as well. They have expanded their services and have accommodated many asset classes over the years owing to technology. But is technical assistance and ease the only advantage of robo-advisors over traditional portfolio management? 

What are the benefits of robo-advisors over traditional financial advisors?

Some robo-advisors need human intervention, and some are automated after you input the necessary information for analysis. However, both kinds have broken certain barriers to traditional investment advisory services. Using a robo-advisor for investment management offers several advantages:

1. Robo-advisors are affordable, often charging less than traditional financial advisors, making them ideal to minimise costs.
2. They provide an automated and user-friendly platform, saving you from the time-consuming task of researching and selecting investments.
3. With robo-advisors, you get a customised investment plan. They use algorithms and surveys to consider your financial goals, risk tolerance, and preferences. Thus, you get a well-researched and statistically calculated investment suggestion. 
4. They invest in a diverse portfolio of assets, spreading risk and reducing potential losses. For instance, they can curate a mix of assets like top AI stocks, long-term investment stocks, ETFs, passive and aggressive growth assets, and debt instruments.
5. You can easily monitor your investments and check their progress with immediate access to your account 24*7.
6. They cater to a wide range of investors, regardless of their investment knowledge or experience. 
7. They use automation and machine learning to make quick, efficient investment recommendations, which can lead to better returns and lower risk.

Despite its numerous benefits, reliance on technology makes it susceptible to drawbacks. 

What are the disadvantages of robo-advisors?

1. If you have sophisticated financial needs, robo-advisors might not provide a wide range of investment options due to their limited flexibility. 
2. They lack a personal touch. So, if you want a personalised experience, traditional investment advisory might be a better choice.
3. Even with advanced algorithms and machine learning, robo-advisors can make errors or miscalculations, negatively impacting investment results. They often rely too much on historical data, which isn’t always a reliable indicator of future market conditions.
4. Robo-advisors, like any investment plan, are vulnerable to market declines and may incur losses during uncertain economic times. The investment decisions of these platforms can be biased since their algorithms are guided by the data they use.

So, while robo-advisors offer several advantages, they might only suit some. Before choosing between a robo-advisor (India) or a traditional financial advisor, carefully assess your financial situation, investment goals, and investment style. 

Conclusion:

Robo-advisory faces significant challenges, including regulatory issues, investor scepticism, and the need for personalised advice in complex situations in India. Collaboration between regulators, industry stakeholders, and the tech community is essential for a secure environment. Despite the complexities, as of 2024, India has 109 robo-advisor startups, according to Tracxn. Moreover, the industry is set for significant growth, with assets under management expected to reach $19.76 billion in 2024 and grow at a 9.21% annual rate, reaching $25.74 billion by 2027. Soon, you may see advancements that include AI integration for better decision-making, enhanced cybersecurity, and hybrid models combining human expertise with automation.

Robo-advisory in India is transforming financial planning, democratising services, and offering precise, algorithm-driven options for diverse investors. As the fintech landscape evolves, robo-advisory becomes crucial to accessible, data-driven securities advisory. 

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