On Sunday the 12th of June, John Oliver devoted an entire episode of his Last Week Tonight show, to exposing how the financial retirement planning industry can take advantage of you. The main takeaway? Professionals might not always have your best interests in mind and even if they do, they might not be much more capable than a cat throwing a toy mouse at a grid of companies. Among the several ways that you can be tricked, the word "Financial Advisors" is not an accredited title (you can now print out your very own financial advisors certificate on John Oliver's website) and their services often come with a host of hidden fees such as legal fees, stewardship fees, bookkeeping fees, finding fees and potentially more.
Coverage by news outlets and various television shows of all the ways in which traditional financial advisory services can take advantage of you, does not bode well for the wealth management industry. The years since the financial crash, Deloitte reports, have been characterized by a rise in a general distrust towards financial institutions, particularly among millennials who are about to become the largest client group for wealth management. While a new regulation, to be finalized within the next few months by the Department of Labor, will require all financial advisors to be held to fiduciary standards (they will be legally obliged to act in their clients' best interest), it is debatable whether this in itself will be enough to restore their clients' confidence.
These trends are widely heralded to benefit companies, such as indexing pioneer Vanguard Group, who offer products that passively track the market. Last year, according to a recent Financial Times article, low-fee ETFs attracted nearly $200 billion while actively managed funds lost $124 billion, representing the first year of net outflow of money from traditional money managers since 2008. In a recent blog post, Russel Kinnel, director of manager research for Morningstar, dubbed this " flowmageddon," in which "ETFs have gained the upper hand in the active/passive debate." Larry Fink, head of BlackRock, commented at the Deutsche Bank Global Financial Services Conference that he was predicting "a massive shift" into passive investment.
However, other players that could benefit from these developments are "robo advisors" who, while gaining a lot of hype since 2008, have recently been cast aside by many market commentators and news pundits. Robo-advisory made its start in the United States in the early 2000s, offering low initial investment minimums and attracting tech-savvy, small investors who otherwise did not have access to established financial advisors. By building software that provide automated, algorithm-based portfolio management without the use of human financial planners, robo-advisor startups were able to drastically cut costs and management fees.
When you first open up an account, you are asked to answer a series of questions, providing them with all relevant information regarding assets and liabilities, age, retirement date and risk appetite, allowing them to build an investment profile for you. Based on this information and through their algorithms which are generally based on a mixture of Modern Portfolio Theory, the Black Litterman Model, the Fama-French Three Factor Model and other assumptions made by their own investment professionals, they build a customized investment portfolio for you which you can follow in real time through your account on their website or through their snazzy smartphone apps.
To date, at around $20 billion, the volume of assets managed under robo-advisors remains small compared to the $33 trillion in potential investable assets. However, these robo-advisors have nonetheless enjoyed astronomical growth and are projected, according to consulting firm A.T Kearney, to become a $2 trillion industry by 2020. In the United States, the two biggest players are Betterment, with $3.9 billion in assets up from $2.2 billion in the spring of 2015, and Wealthfront, which according to its most recent filling with the Securities and Exchange Commission, has $3 billion in assets, and 68,000 accounts under management.
In an article Barron's ran last year when markets were still booming, it argued that the question that remained unanswered was how robo-advisors would do once a market correction hit. However, both Betterment and Wealthfront thrived through the volatility experienced at the beginning of this year. "When January hit, and the market was down the most it's been in the last five or six years, we saw our fastest growing month ever" Betterment founder and CEO John Stein reported. Interestingly, Betterment reported, much of its new assets came from rollovers from 401(k) and IRA accounts. These are not impulse deposits from curious customers but rather retirement money that is considered stable and is not expected to move around much in the coming decades.
Beyond the advantages of lower costs, zero paperwork, and an easy, transparent interface, robo-advisors argue that their advantage lies in being able to eliminate bias in the same way that an ETF or index fund does. "On a scale of one to ten, how would you rate your driving skills?" Betterment asks on its website, "Most likely it's a seven, and you're not the only one. But statistically speaking it's impossible for most people to be above average." This is an example of overconfidence bias, Betterment tells us; other biases that can afflict both individual and professional investors include empathy gap, short-term gratification, and many more.
Of course, it goes without saying that robo-advisors still have shortcomings and face significant challenges in their quest to make a substantial dent into the traditional wealth management market. Some critics point to the limits of customization. No two individuals' financial planning will be the same, even if they have similar backgrounds. Others argue that once your financial plan is in place, robo-advisors will not be in a position to address a sudden monetary change in the life of the user. As robo-advisors continue to gain experience with their models and refine their software, however, concerns over both of these issues should be assuaged.
While robo-advisory might be well suited for small investors, for bigger clients, Business Today notes, trust remains an issue. For many, trusting a human advisor with your hard-won money comes more easily than trusting a computer. At this stage furthermore, tax optimization for larger clients remains an aspect which robo-advisory, as of now, cannot really handle.
Finally, critics point out, scale is of paramount importance. Being very cheap, robo advisors need lots of assets to make a profit, The Economist argues. Currently, Wealthfront and Betterment's approximate $3 billion in assets under management deliver revenues of around $7 million a year, not nearly enough to sustain a staff of around 100 as well as expensive marketing budgets. Total costs, The Economist believes, are likely to be more around $40 to $50 million a year (neither firm discloses the data). For these robo-advisors to survive, it will be vital for them to reach a certain scale, as every new client brings in new revenue at little extra cost.
"To be successful," Sean Park of Anthemis, an investment firm that has backed Betterment says, "[a firm] needs to manage tens of billions; to be really successful they need to manage hundreds of billions." In the meantime, they are simply living off of the largesse of venture capitalists who poured nearly 300 million into various robo-advisors last year.
While critics raise valid concerns as to the challenges and limitations robo-advisors face, what seems certain is that robo-advisors will have a profound impact on the wealth management industry. First of all, profit margins in the asset management industry will undoubtedly face substantial downward pressure. In 2014, according to a BCG report, profit margins in the asset management industry were an average of 39% compared with 8% in consumer goods and 20% in pharmaceuticals, allowing investment managers to be paid an average of $690,000 a year. When markets are rising, The Economist argues, clients may not notice the impact of fees that have been protecting such high margins but "now the tide has gone out and the emperor has no clothes".
Furthermore, wealth management and financial services are facing technological disruption. "It's not a question merely of the degree of change now" Barron's writes, "but rather how much there potentially will be in the future." Wealth management and financial services in general, it argues, have been laggards when it comes to the disruptive effects of technology. The fact that technology, will change how money is managed and channeled, must be accepted, rather than feared or fought. Barron's does not think that it will eliminate the need for wealth managers but rather that it will enhance it. Traditional wealth managers that most quickly realize this will be most likely to succeed.
To survive, traditional wealth management firms themselves will have to move in to the digital age. Millennials, according to the Deloitte report, consider technology and online platforms an important aspect of financial advice, and 57% would change their bank relationship for a better technology platform. In 2015, over 80 percent of millennials owned a smartphone with numbers steadily rising, and 89 percent of those check their device within the first fifteen minutes of waking up. Leveraging this kind of interaction should therefore be a priority for wealth management firms.
Bank leaders including Morgan Stanley chief executive officer James Gorman and Well Fargo chief executive officer John Shrewberry have gone on record saying that their firms must develop robo-advisors to complement their advisor sales force. In addition, companies such as Schwab and Vanguard have unveiled their own software that can design an investment menu based on the answer to a set of questions that human advisors traditionally ask. Banks must adapt or perish.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.