Online advice is a hot topic, frequently the subject of animated and often heated discussion at industry gatherings. In most conversations, I sense both fear and greed in the sentiments expressed. Today’s advisors have had a front row seat as technology innovations have reshaped many businesses: changes in the travel business, book sales, music and the post office haven’t been positive for most workers in those industries, so the fear factor for advisors is understandable.
It’s also easy to understand the hint of greed in conversations about online advice, as advisors that are able to harness technology may be able to serve new client segments, manage existing relationships more efficiently and offer new services.
Curb Your Enthusiasm
The term “robo-advisor” is becoming ubiquitous, though we must admit to having a disturbing vision of the former governor of California whenever the term is used.
Hyperbole from online advice providers may invite some of the disdain coming from established financial firms. One of the best known online advice providers has compared itself to Apple, another to Schwab. Those kinds of comparisons remind me of the heyday of the technology bubble, when hype often substituted for sound investment thinking.
Apple transformed the computer industry by providing fun, easy- to-use computers; changed an entire way of life for music listeners with the iPod; and for its next act created a world of mobile computing and communication with the iPhone and iPad.
In financial services, Schwab was equally as innovative with a series of game-changing initiatives that transformed and democratized the investment landscape. Today’s Schwab is a giant that provides investment advice, brokerage services, banking and a host of other services to clients in person, online and by phone. Today’s online advisors may at some point have the same impact on the world as Apple and Schwab, but the comparisons at this point are aspirational rather than realistic and from a cynical point of view seem driven by a need to keep venture capital funding flowing.
We’d like to step away from the hype and appealing websites to examine the current state of the online advice industry. We’ll provide an overview of the early leaders in the industry, outlining the investment approach of each firm, and pose questions to be asked as the industry evolves.
The Most Widely Publicized Firms: Betterment, Wealthfront and Personal Capital Betterment and Wealthfront are primarily online providers, offering online support rather than a relationship with a human advisor. Personal Capital offers an approach that combines elements of the virtual and traditional advice world, using technology to augment the role of a human advisor.
Personal Capital offers more additional services than Betterment and Wealthfront, aggregating investment information as well as providing diagnostics to help clients assess 401(k) and mutual fund fees. Betterment and Wealthfront are low cost providers, with Betterment charging annual fees ranging from 0.15% to 0.35% and Wealthfront offering their services for free to small accounts and for 0.25% for accounts greater than $10,000. Personal Capital has a fee schedule that starts at 0.95%, which is comparable to traditional advisory firms and reflects the availability of a broader relationship with an advisor.
Each firm has a “dream team” of leaders, venture capital backers and advisors. Wealthfront has as its chief investment officer Burton Malkiel, the author of A Random Walk Down Wall Street, as well as an advisory board that includes Meir Statman, one of academia’s experts on behavioral finance and renowned consultant and author Charley Ellis.
Betterment is backed by prominent venture capital firms and recently added industry thought-leader Steve Lockshin to the fold as an advisory board member and leader of the Betterment Institutional offering.
Personal Capital was founded by Bill Harris, former CEO of Intuit and Paypal, and is backed by a who’s who of Silicon Valley venture capital providers and a board that includes industry leaders such as Charles Goldman and well known venture capitalists such as Steve Harrick.
Their Investment Approaches
Most articles about online advice focus on the online user experience, growth of assets under management and funding from venture capital firms. Few have examined the investment philosophy and approach used to manage client assets. Betterment, Wealthfront and Personal Capital have absorbed important lessons from John Bogle, embracing the importance of managing costs and taxes. Beyond a focus on costs and taxes, the firms have somewhat different approaches to investing.
Betterment builds diversified portfolios primarily using ETFs, attempting to boost after-tax returns through technology that helps them efficiently “harvest” tax losses while maintaining a consistent strategic asset allocation. In a nod to Fama/French, Betterment tilts its portfolios to emphasize small cap and value stocks. Betterment’s website features an aggressive marketing approach, claiming more than a 4% expected performance advantage relative to alternative investment approaches. Betterment’s performance advantage is attributed to passive investing, better diversification, automated rebalancing and encouragement of “better behavior.”
Advisors who already use low-cost ETFs and funds to create diversified portfolios may bristle at some of Betterment’s claims of such a performance advantage. The “better behavior” comes from Betterment’s assertion that it can help investors avoid destructive trading and market timing behaviors. I think it reasonable to question how effective pop-up reminders and white papers will be if we revisit the turbulence of the financial crisis or the aftermath of the technology bubble.
Wealthfront was the first of the new breed of online advisors to reach $1 billion in assets, helped by its Silicon Valley connections and a pricing model that offers services for free to investors of less than $10,000, while charging 0.25% for the rest of their clients. Wealthfront makes similar performance claims to Betterment and offers diversified portfolios built around low cost ETFs that are loss harvested to increase after-tax returns. Wealthfront’s approach relies upon core ETFs providing exposure to equities, bonds, real estate and natural resources. Unlike Betterment, Wealthfront doesn’t tilt its portfolios to favor value or small cap stocks. Clients who invest more than $500,000 can invest in a portfolio that combines U.S. stocks with ETFs, with the U.S. stock investment increasing opportunities to harvest losses.
Personal Capital’s offering, given its diagnostic tools and availability of a personal advisor, may provide a broader solution set than the purely online advice offerings. Personal Capital’s investment approach is centered around a diversified portfolio that has individual U.S. equities at its core, supplemented by ETFs to provide exposure to other asset classes.
The Personal Capital approach to equity investing is significantly different than that of most online and traditional advisors, with portfolios featuring an equal-weighted sector approach. Under Personal Capital’s equal weighting approach, each economic sector is weighted equivalently within the portfolio. The implications of that approach is that sectors such as utilities and telecommunications, which are small from both a market capitalization and fundamental perspective, have the same portfolio weighting as economically meaningful sectors such as financial services and technology.
To Conclude, Three Questions to Ask
What About Those Back-Tested Results? Each firm points to back-tested simulations to justify their strategy. How have their strategies performed with live portfolios, and under what circumstances would they expect performance to disappoint? How will these live portfolios perform in the next market crisis?
What About Robo-Advisors’ Own Economic Models? Skeptics have questioned the viability of the online advice model. As one observer pointed out, $1 billion at 0.25% doesn’t generate the money necessary to pay an army of software engineers, nor does it fund the marketing necessary to gather the attention of consumers bombarded with advertising from deeper-pocketed financial services firms. What is the economic model, how will it change over time, and what is the break-even level of assets?
What About Differing Client Profiles? What happens to clients who don’t fit the textbook profile of funding with cash, having a portion of their assets in a taxable portfolio, and having an accumulation-oriented goal? What are the future plans to work with clients who have an existing portfolio of stocks and mutual funds? What about clients who don’t benefit from tax harvesting, including 401(k) investors? Will these firms provide advice to clients who have current income needs rather than wealth building needs?
While being somewhat critical of the hype, we are enthusiastic about the potential for online advice providers to “democratize” the investment process, bringing services that heretofore have been confined to higher-net-worth investors (such as tax loss harvesting) to the masses. Also, we’re aware of the potential impact on the “marginal” advisor that may charge high fees for either a poor performing or commoditized approach to investment management.
Just as the popularity of low-cost ETFs shone an unflattering light on expensive, “closet-index” mutual funds, we suspect that the popularity of online advice providers may cast a similar light on advisors that are charging high fees for creating diversified, index-oriented strategic portfolios.