If you’re familiar with the basics of investing, then I’m sure you’ve heard of terms like “mutual funds” and “ETFs.” In a recent Yahoo! Finance article, robe-advisor firm Wealthfront challenges the status-quo by saying that their direct investing approach will beat ETFs at their own game.

Really? So will this happen? Let’s take a look.

In case you aren’t too familiar with the concept or you just need to shake off the rust, diversifying your investments is a  central idea to finance. Mutual funds and exchange traded funds (known as ETFs), hold diversification as their central  tenant.

Diversification, of course, is the whole idea of being able to have all of your eggs in one omelet, but just don’t put all  your  eggs in one basket.

And, so long as you remember, the idea is as long as one region, sector, industry, or even point of view (like normal  goods, depression goods, sin goods, etc.) suffers significant hardships then you still have the remainder of your  portfolio to offset potential losses.

Finance at its finest.

It’s true that diversification has taken greater steps forward over the last few decades. In fact, the advancements of technology have taken the realm of finance into a brand new idea (or at least they claim it to be a new phase anyway). With the ability to program, process, compute, and spit the world into algorithms and complex math formulas, the world of finance has continued to churn out more sophisticated ideas in less time than it takes us to compose thoughts.

So, for me, the idea of robo-advisors is the obvious next move in a long line of advances.It’s also why, just like with every other advancement, strong proponents of robe-advisors think they’re not only the future, but they will bring the future to us now.

The Truth About Robo-Advisors – ETF + Tax Efficiency

The specifics about using these robo-firms is that they truly are nothing “new.” In fact, just like you could argue that robots themselves are nothing more than a scaled up version of programmed commands, the way in which they operate is truly basic as well. By programming in rules for these robo advisors to follow, the basic idea is that a robot or program can execute trades to sell off a falling stock, take a position in a similar stock (at least a comparable one from the indexed position), but still manage to capture the losses of the original stock. The end result is that the investor retains the original (at least similar) makeup of the ETF which was owned in the beginning, but they have also captured losses with a hefty tax benefit as well (currently up to $3,000 can be used to reduce taxable income annually). It’s not the system that is so sophisticated; it’s a simple set of algorithms and rules that just happen to be carried out to perfection.

I’m not the only one calling robo-advisors ETFs. Burton Malkiel (one of those arguable “founding fathers” of modern finance) is calling this the next big thing. He says robo-advisors, in fact are not a fad or a substitute, but a more efficient upgrade onto existing ETFs. The idea is that this strategy truly is, at it’s heart, an exchange traded fund and comes with all of the benefits of a normal fund; it just has the added bonus of positive tax implications.

Furthermore, the most important point to make isn’t just the ability to save $3,000. (By the way, if you are willing to toss aside $3,000 just for fun, I’m sure there are a few places you could send it if you just email me!). While the $3,000 annual tax harvest truly can add up to be a pretty impressive chunk over the course of several years, the fully implemented strategy is about deferring the tax liability. Over the course of the entire portfolio life (or even for a long time), a “tax loss harvesting system” as it has been called will accumulate and will allow investors to have significant taxable benefits on their side all while obtaining the original assets for pennies on the dollar.

As Malkiel puts it, “tax deferral translates into real money when the savings can be reinvested and compounded.”

What is a robo-advisor, then? Basically, it’s an EFT with an option to supercharge and grow due to the tax benefits.

Marketing To The Masses – You and Me

Some have already pointed out that this strategy is not necessarily brand new, but it has been used by some institutional investors in the past. The benefit of course is that while institutional investors and the rest of the elite may have had access to this, they probably don’t pay much attention to the engine under the hood. By refining this strategy, robe-investing could be a major jump with smaller players coming into the picture for their piece of the pie.

Of course, just like most “new strategies,” there are already some naysayers. And who is to say they are wrong?

That being said, if you don’t have a history book handy it still won’t be hard to remind any investing buff the way that diversification pioneers were treated when they brought about prior items such as mutual funds, EFTs, or even a modern day stock market on the internet. (Can you even imagine a world without online trading!?). All of them were panned by the naysayers.

The Future of Robo-Investing

So, while there is no-one calling this a sure thing, the simple idea of enhancing current day funds with tax benefits and the ability to jump returns is at least appealing to the full spectrum of investors.

Plus, even if those who invest don’t have the ability to capture as significant a tax advantage as is being proclaimed, the fact of the matter is you are still investing in a vehicle that is an ETF at its roots.

Even if the tax benefit doesn’t fulfill your hopes and dreams, you won’t have to worry about losing out on the market. The worst case scenario is that you have still eliminated risk, diversified your position, and while you might have had your hopes dashed, you haven’t lost a significant position to try and jump on board a new train before it leaves the station. Unless of course you are investing solely in trains, in which case that’s an entirely different lesson for a different day……

Really, This Is About Innovation

Robo advisors are not just bringing about a new product, but they continue to show how thinking outside the box is enabling a significant amount of efficiency and accuracy to be injected into what some regard as the best vehicles out there today. By covering positions even more with a shield, losses incurred in a normal ETF can truly be captured and turned into an advantage. What used to be a boulder sized loss is now literally being catapulted thanks to the next wave of technology.

And while there are some who think that this could be more of a fad and that some net bonuses are being overestimated and not what they are cracked up to be, there are others who think at worst this is just another added service and a potential option for those who do believe in the power of robo-advisors for an investor without the assets to hire a full-fledged pro in their corner. Even if they don’t know where it will lead, it’s thrilling to see new pioneers of investing. Even though Christopher Columbus sailed the ocean blue and discovered the new world, every other sailor on the ship who went along for the ride also made it there as well. These investors don’t need to create or refine this strategy, but they can still possibly tap into a more efficient vehicle and what could be the next “norm” in the marketplace before it becomes too popular.

What’s Next?

As with waves of innovation before this, no one truly knows how this one will play out. There doesn’t seem to be a lot of downside. What’s the worst that could happen? You could take a chance at something new and wind up overpaying for a fairly standard ETF (I’m sure you can already point out a handful of customers and clients who do that anyway but without the upside). While the upside is potentially significant gains that only increase over time. It truly could be an upgraded form of diversification.

The most important thing to do at this time would be to try and decide if this is something for you, as there might not be a lot of opportunity to test it out before the market finds a correction, starts making it more difficult (financially of course) to tap into this possibly proven strategy. On the other hand, I don’t know that trusting all of your money to a robe-advisor is a good idea. When has it ever been a good idea to throw money at the next big thing just because it could be big? After all, there’s a sucker born every minute and if you are going to realize you’re a sucker, hopefully you aren’t burning money in the process as well.

Invest with confidence and caution. Understand the products you want to put your wealth (i.e. your future) in. And above all else, know more about your assets then the people who handle them. This might just be a boy who cried wolf, but with some due diligence and a little bit of faith you could be spring boarding yourself to a more diversified system of nicer returns.

Phil is a firm believer in not just understanding how finance works, but someone who thinks investing and business should be connected to every part of our lives and not just a segment of it. “By reading the thoughts of others, we can get caught up. By merging our views and connecting ideas, we can move forward and grow.”

Photo: Frankieleon