We examine how robo-advisors have evolved over the past decade to determine if their services justify the fees they charge.
Topics covered include:
- How large are the top 5 robo-advisors
- Robo-advisor fees
- Robo-advisor holdings
- Why robo-advisors are turning toward direct indexing for tax loss harvesting
- How much excess return does tax loss harvesting generate
- Who can benefit from using robo-advisors
Show Notes
An Empirical Evaluation of Tax-Loss Harvesting Alpha by Shomesh Chaudhuri et al.—SSRN
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Transcript
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 529. It’s titled, “Are Robo-Advisors Worth It?”
Recently, I received an email from a member of our membership community, Money for the Rest of Us Plus. She was curious about my thoughts on robo-advisor platforms. She has invested with Betterment in her HSA account and has a brokerage account with Wealthfront.
She’s read some reports that these robo-advisors that offer tax loss harvesting—which I’ll explain in a minute—that that’s more of a marketing gimmick, and doesn’t really add a lot of value. And then there was the concern that while their fees are so low and they’re not profitable, and potentially they’ll have to raise fees in the future. So in this episode, we’re going to take a look at robo-advisors, we’ll look at tax loss harvesting, the potential benefits of that, and an element of tax loss harvesting called direct indexing.
What Is a Robo-advisor?
First, a robo-advisor it’s an account that—they started just over a decade ago, maybe it’s been 15 years now, but they have low account minimums. Often zero. You go through a process of answering questions to determine your risk profile, and it’s all automated.
So there’s no individual that you’re working with. It’s all done online. Once the robo-advisor platform determines your risk profile, your portfolio objectives, it selects an asset allocation and chooses the underlying investments, which are primarily exchange-traded funds.
The robo-advisor will rebalance your portfolio, and it may offer tax loss harvesting.
What Is Tax Loss Harvesting?
Tax loss harvesting is a strategy where investments that have dropped in value are sold to realize a capital loss, which can then offset capital gains, reducing one’s taxable income. Once that asset is sold, it is typically invested in a similar type asset. It could be an ETF, or if it’s a strategy that is selling individual stocks, it could invest in a stock that has the same industry or same characteristics.
In the U.S. there’s something called the wash sale rule, and it says that you can’t claim a loss when selling a security if you buy the same or a substantially identical security within 30 days before or after the sale. This gets a little fuzzy when it comes to robo-advisors, because they’re using exchange-traded funds, and if they’re practicing tax loss harvesting, they might be selling one ETF—let’s say it’s a small-cap ETF—and then buying a small-cap ETF from another sponsor or provider, even though the overall underlying holdings are substantially the same.
But it appears the IRS has allowed that because these robo-advisors have been practicing that form of tax loss harvesting from one ETF to another, and apparently, the IRS has determined that they are not substantially identical.
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