Robo Versus Direct Investing

I was talking to a friend the other day and she was saying that she and her husband use Wealthfront as an investment service.  Wealthfront, like Betterment, is a robo-advisor service that charges low fees (at least, low for the industry) and uses sophisticated algorithms to make sure your money is getting invested to your greatest advantage. 

The discussion made me wonder, what if you invested directly in VTI (Vanguard’s Total Stock Market Index ETF) as opposed to having your robo-advisor do it for you.  What is the difference in investment return.  First, a few facts for our hypothetical:

–  Tax Advantaged Accounts Only;

–  Starting Portfolio Value of $1 million;

–  ETF fees for VTI currently at 0.04%/yr;

–  Wealthfront has no charge on the first $15k, then 0.25% of balance; and

–  No taxes withheld. 

I used 0.5% for the entire 15 1/2 years of ETF calculations because I know the fee has decreased to current levels since inception, so I used a slightly higher number each year to account for the difference.

Going back to 2002 (first full year of VTI) and coming forward to mid-2017, the result is that the $1 million portfolio invested and left in VTI grows to $2,342,659.  Invested through Betterment, it grows to $2,268,771.  A difference of almost $74,000 or 3.25% difference in return.  Who gets that money?  The robo-advisor. 

This is what the annual results look like:

Now this is not to say that money invested with a robo-advisor would not do better than money invested directly into a Vanguard ETF (or mutual fund).  It could be that the AI algorithm used by Weathfront, Betterment and other businesses of this type will consistently out-perform the market.  But we know from much research on the issue that only about 20% of managed funds beat the broader market (and that it is usually not the same 20% each year), so it seems prudent to assume that in the long run, an index fund/ETF will come out on top. 

Also, if you are investing in a taxable account, the algorithm, using complex tax loss harvesting methods, might increase your return relative to the market.  That is very difficult to measure in this type of analysis.  For that reason, we are assuming that money is being invested in tax advantaged accounts. 

What is the lesson here?  It’s pretty simple, and one you’ve heard before:  If you are investing for retirement, automate the process and invest regularly in broad, low-cost index funds or ETFs (like VTI from Vanguard).  Then, it’s just a matter of  living long enough to harvest the gains and to enjoy the bounty of your diligence, patience, and the magic of compounding.

Until Next Time, FIRE On! – Oldster