If you're thinking about an easy way to save for retirement, you might be considering a robo-advisor, an index fund, or a target date fund. These are all popular choices to build a diversified portfolio without too much hassle or cost. But what makes them different, and which one is right for you?
This article breaks down the key features, pros, and cons of each option, helping you figure out which one fits your needs best.
What is a robo advisor?
A robo-advisor is an online service that uses computer programs to create and manage your investment portfolio. To begin with, you will be required to answer questions about your objectives, risk tolerance, and time horizon. Based on your answers, the robo-advisor will suggest a suitable mix of low-cost exchange-traded funds (ETFs) covering stocks, bonds, real estate, commodities and other asset classes.
The robo-advisor will also automatically rebalance your portfolio, modify your asset allocation as you approach your goal, and explore tax-saving opportunities. Robo-advisors usually charge an annual fee of about 0.5% of your account balance, in addition to the expense ratios of the ETFs they use, which are generally below 1%.
You'll find “native” robo-advisors that started out as algorithmically inspired investment platforms like Wealthfront and Betterment. Most trading platforms like Schwab, Fidelity, and Vanguard also have their own version of a robo-advisor.
What is an index fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that follows the returns of a particular market index, such as the Nasdaq 100 or the S&P 500. Index funds offer a low-cost and passive way to invest in a broad range of securities representing a specific market segment. They have low expense ratios, usually around 0.06%, and low turnover, which means they trade less frequently and incur fewer taxes and commissions.
You don't have to manage index funds actively, so you can buy and hold them long-term. However, you will need to decide how much to allocate to each index fund and how often to rebalance your portfolio to maintain your desired risk level.
QQQ and SPY are well-known index funds, and Vanguard index funds like VOO are generally low cost.
What is a target date fund?
A target date fund is an investment fund that adjusts its asset allocation based on your expected retirement date. For example, if you plan to retire in 2050, you might choose a target date fund with a 2050 date. The fund will start with a higher percentage of stocks, which offer higher returns but also higher risk, and gradually shift to more bonds and cash, which offer lower returns but also reduced risk, as you approach your retirement date.
This way, you can benefit from the growth potential of stocks when you are young and protect your savings from swings in the market when you are older. Target date funds are an easy and convenient way to invest for retirement. However, they have some downsides, such as higher fees, limited customization options, and different performance levels among different fund providers.
Most target funds will be named with the advisor and then the target date, like Fidelity Freedom 2060 Fund (FFSFX).
Robo-advisors vs target-date funds
Both robo-advisors and target-date funds aim to provide long-term growth and reduce risk. Still, their performance may vary depending on market conditions and the specific investment strategy used.
Robo-advisors are good for people who want a personalized approach to investing. They ask you some questions about your financial goals and then create a customized portfolio for you. On the other hand, target-date funds are simpler, with a one-size-fits-all approach. They only use your expected retirement year to select investments for your portfolio.
Cost-wise, robo-advisors usually charge an annual management fee based on a percentage of your investments. In contrast, target-date funds usually do not charge a separate management fee but rather have an expense ratio reflecting the costs of the underlying funds. This expense ratio can vary widely, depending on the fund provider and the level of active management involved. Therefore, target-date funds may be cheaper or more expensive than robo-advisors, depending on the specific fund and robo-advisor you compare.
Robo-advisors also offer more flexibility and control over your investments. You can change your portfolio allocation, deposit or withdraw money, and choose from different account types. Target-date funds, on the other hand, offer less control and are usually only available in retirement accounts.
Robo advisors vs index funds
Robo-advisors and index funds are known for their low-cost approach, yet they differ in various aspects. Robo-advisors provide a convenient, hands-off solution with personalized advice but may lack the flexibility of managing your own portfolio. Index funds, on the other hand, offer more control and customization at a lower cost, making them a suitable choice for those who prefer a hands-on approach to investing.
Robo-advisors allow you to invest in a diversified portfolio without the need for much hands-on involvement. This automated approach suits those who prefer a more hands-free investment process. Robo-advisors also provide personalized advice and guidance, tailoring recommendations to your financial situation and objectives based on your goals and risk tolerance.
On the other hand, index funds require a more do-it-yourself approach. Investors manually select and balance their portfolios of funds that track different market indexes. This process gives you more flexibility and control over the specific funds and weights in your portfolio, allowing you to customize your portfolio to your taste.
Robo-advisors usually apply a fee, a percentage of the assets under management. This fee is in addition to the expense ratios of the funds the robo-advisor invests in. In contrast, index funds generally charge a single annual expense ratio, which is the only fee investors pay.
Target date fund vs index funds
Target-date funds are actively managed, aiming to outperform the market by selecting and rebalancing the funds within the portfolio. This approach involves strategic decision-making by fund managers to achieve better-than-average returns.
On the other hand, index funds take a passive management approach. Instead of trying to outperform the market, they track a specific market index, striving to replicate its average return. This passive strategy involves less frequent trading and decision-making.
Being more actively managed, target-date funds typically come with higher costs. These funds charge a management fee for overseeing the fund and an expense ratio covering all the funds within the portfolio. In contrast, index funds have lower fees because of their passive management style, involving fewer transactions and less active decision-making.
For example, the Fidelity Freedom 2060 Fund (FFSFX), a target-date fund that invests in a mix of Fidelity's actively managed funds, has an expense ratio of 0.75%. This fee is significantly higher than that of the Fidelity Total Market Index Fund (FSKAX), an index fund that tracks the performance of a broad range of US stocks with an expense ratio of 0.01%
Regarding performance, target-date funds may underperform the market and index funds. Their more conservative and diversified strategy might not fully capture the market's potential. On the other hand, index funds, by reflecting the average market return, may perform better than actively managed funds over the long term.
Factors to consider when choosing between robo advisors index funds and target date funds
Robo advisors, index funds, and target date funds are all popular options for investors who want a simple and low-cost way to build a diversified portfolio. Here are some factors to consider when comparing them:
Risk tolerance and investment horizon
This is how much risk you are willing to take and how long you plan to invest. Robo advisors typically ask you a series of questions to assess your risk profile and then recommend a portfolio that matches your goals and preferences. Index and target date funds do not have this feature, so you must decide how much risk you are comfortable with and how to adjust it over time.
Target date funds are designed to reduce risk automatically as you approach your retirement date, but they may not suit your specific needs or expectations. Typically, you are not meant to withdraw target-date funds before the target date, though it's possible.
Index funds are passive investments that track a market index, like the S&P 500, and they do not change their risk level unless you rebalance your portfolio manually or through another service. You can also pull your funds at any time without penalties.
Fees and costs
Robo advisors charge an annual fee for managing your portfolio, usually around 0.5% of your assets. They also seek out low-cost ETFs (together with other criteria), to build a portfolio that helps minimize the overall costs. Index funds and target date funds are mutual funds that you can buy directly from a brokerage account or a retirement plan, such as a 401(k) or an IRA. They do not have an advisory fee but typically have higher expense ratios than ETFs. The lower the fees and costs, the more money you can keep in your account and benefit from compound growth.
Level of involvement and control
Robo advisors are great for investors who want a hands-off approach and trust the algorithm to handle everything for them. They offer automatic rebalancing, tax-loss harvesting, and other features that can optimize your portfolio performance and reduce your tax bill. However, you have limited control over the asset allocation and the fund selection, and you may not be able to customize your portfolio to your specific needs or preferences.
Index and target date funds give you more control over your investments, as you can choose which funds to buy and how much to allocate to each. However, you are also responsible for monitoring and adjusting your portfolio as needed, which can be time-consuming and stressful.
Diversification and asset allocation
Diversification can reduce your portfolio risk and increase your returns over the long term. Robo advisors offer a high level of diversification, investing your money in a wide range of ETFs covering various markets, sectors, and regions. They also use sophisticated algorithms to determine the best asset allocation for your risk profile and goals. Index funds and target date funds are also diversified but to a lesser extent.
Index funds typically focus on one market or sector, such as the U.S. stock market or the technology sector, and they do not offer other asset classes, such as international stocks, emerging markets, or real estate. Target date funds are more diversified, investing in a mix of stocks and bonds that change over time. Still, they may not include alternatives or niche markets, such as commodities, cryptocurrencies, or ESG funds.
Historical performance and track record
Historical performance describes how well your investments have performed in the past and how consistent they have been. However, it does not guarantee future results, but it can give you an idea of each option's potential returns and risks. Robo advisors are relatively new in the investment industry, so they may not have as long of a long track record to compare with other options. Index funds and target date funds have a longer history and more data to analyze, but their performance can vary depending on the market conditions, the fund manager, and the fund quality.
The Robo Report by Condor Capital, Wealthfront ranks the performance among 50 robo-advisors.
A snapshot:
One Year Total Performance Winner: Fidelity Go, 2nd: SoFi, 3rd: Vanguard P.A.S.
Three-Year Total Performance Winner: Schwab Domestic Focus, 2nd: Wealthfront (2016), 3rd: Zacks Advantage
Five-Year Total Performance Winner: Zacks Advantage, 2nd: Wealthfront (2016), 3rd: Fidelity Go
Of course, past performance does not guarantee future results.
Choose your passive investment carefully
When choosing between a robo-advisor, index funds, or target date funds, your decision should be based on your personal preferences, risk tolerance, and investment goals. Robo-advisors offer a personalized, hands-off approach with some flexibility, but they also come with associated fees, which may be comparatively higher. Index funds may be right for you if you prefer a more hands-on approach, as they provide control and low costs.
On the other hand, target date funds offer simplicity and automatic adjustments based on your retirement date, but they may have higher fees. When deciding, consider your level of involvement, risk tolerance, and desired diversification. The right choice depends on your individual financial preferences and objectives.