Plenty of services have been disrupted by technology. When was the last time you used a travel agent? How many of us use tax software instead of an accountant? Is financial advice about to be taken over by technological innovation? Or will it simply improve the quality and efficiency of in-person advice, as it has in numerous skilled professions from medicine to graphic design?
Many of the first robo-advising services arguably suffered from a general ignorance of the financial advising profession. I can imagine that entrepreneurs called in famous finance professors and asked them how to automate investment advising. To a finance professor who doesn't really understand the profession, it's all about making investment portfolios more efficient. So that's what the robos did.
Building a well-diversified, tax-efficient passive portfolio that automatically rebalances isn't rocket science. Many advisors have been using technology to help with these tasks for years. This type of mechanical portfolio management is also remarkably scalable and cheap. It is a commodity, and those who provide the service at the lowest cost will attract the most investment dollars. Financial services companies (for example Charles Schwab & Co.) recognize this and now offer the service for free in order to attract investor dollars to its financial products.
Not surprisingly, this competition has caused a flood of inflows into the lowest cost providers as growth in some of the most famous first-mover robos has stalled. Recently, Wealthfront CEO Adam Nash touted the potential of artificial intelligence as a possible way to resurrect some excitement about the company. But the reality is that investors attracted to the original concept of an automated portfolio manager have largely been captured.
The first rule of robo-advising is that the robo part (rebalancing, tax efficiency) may not be worth the cost of admission. According to David Blanchett, head of retirement research at Morningstar, “many of the robos are significantly over-representing the benefits of tax loss harvesting.” And rebalancing isn't that difficult.
The reality is that an investment portfolio that automatically rebalances and changes allocation to match age and risk tolerance is already available at a lower cost in target date ETFs. At 15–30 basis points plus ETF fees, this means that it may be hard to attract sophisticated do-it-yourself investors. When your product is an easily replicated technology, there is no moat protecting your business model.
In a recent article comparing returns on mutual funds sold directly to investors versus those sold through brokers, Boston College finance professor Jonathan Reuter identifies two distinct types of investor — one who is sophisticated and self-directed, and the other who relies on a broker to guide investment choice. Sophisticated, self-directed investors care about fund expense ratios and net performance. Those who rely on a broker don't.
According to Reuter, “robo-advisers may appeal most strongly to investors who already have a preference for low cost mutual funds and are therefore conditioned to focus on fees. The long-run result may be robo-advising services that all offer similar portfolio management services and charge similar prices.”
It is these self-directed investors who have made Vanguard the second largest asset management firm in the world. They’re also the ones most likely to recognize the value of services that increase the net, risk-adjusted return on their (mostly) passive portfolio. They’ll be the first adopters of technology that improves performance.
They’ll also be the first to leave if they can get a better deal. They’re the investors that robos seemed to be attracting through marketing that bashes the expense of traditional advisors. And self-directed investors aren't sticky.
It shouldn't be surprising then that Vanguard's Personal Advisor Services project, which mixes the ability to talk with a remote human advisor along with passive, efficient investing strategies at a cost of 30 basis points, has more than doubled over the last year to over $36 billion in assets — a figure that is five times the combined assets of Betterment and Wealthfront, the two largest robo advisors. Investors also get access to lower cost (10 basis points less) admiral shares as well as access to an actual human advisor who can tailor an investment plan to an individual's needs.
Who is going to be a client of Vanguard's remote in-person advising service? According to Frank Kolimago, head of Vanguard Personal Advisor Services, “the vast majority of clients who’ve adopted the service are existing Vanguard clients.” And when do they decide to pay a little extra for advice? “About two-thirds of our clients are within 10 years of age 65,” notes Kolimago. In other words, they pay for advising when they have questions they can't answer themselves.
About 40% of client interactions are through virtual video conversations. Kolimago points out that “clients are embracing the video consultations. Technology is allowing us to do things that we never would have imagined 20 years ago.”
Research has shown that clients may well know what they need to do in order to invest properly and reach their long-term goals, but reason gets thrown out the window when markets get turbulent. Instead of losing a few basis points here and there to less-than-perfect portfolios, individual investors lose over 100 basis points a year to bad market timing (buying high and selling low). They may not even be able to stomach an appropriate amount of investment risk without the ability to phone an advisor during a bear market.
Most inexperienced investors who work with advisors that provide an imperfect product are perfectly happy. And the existence of a new, impersonal advising platform that ekes out a few extra basis points in return isn't that compelling to clients who have no idea what they’re currently spending on their investment portfolio. In fact, Reuter points out that a new study found that competition from cheap index funds actually increased the cost of broker-sold funds as it drove more price-sensitive investors out of the market.
The most likely outcome is that investors who care about arcane things like net return will recognize the advantage of automated investment management and then search for the lowest-cost provider. The best many robos can hope for is that a new generation of less sophisticated investors who prefer an online to an in-person advising environment will remain loyal to the robo platform they’re familiar with.
Betterment has done a good job of developing an online goal-based advising process that provides planning value in addition to asset management. It remains to be seen whether loyal clients who start out using this online advising process will remain loyal to their robo.
Another type is the traditional advising client who is looking for advice that extends far beyond an investment portfolio. For this type of client, robos will cause advisors to refocus on the value proposition they provide that justifies their added expense over automated or remote advice.
Some companies are recognizing the potential to use technology as a means of helping traditional advisors do a better job of providing holistic advice. Morningstar, for example, is gearing up to provide a suite of services that use technology to help the advisors develop planning strategies that go beyond investment management. According to Tricia Rothschild, head of global advisor and wealth management solutions, robo advice may work for clients whose needs are basic but doesn't work as well for clients that require help on more advanced topics.
“My nephew, for example, who is a single, 32-year-old elementary school gym teacher, is perfectly well suited for an automated advice offering where he pays a nominal basis point fee. My husband and I, on the other hand, would not be well suited for this kind of service. We want to understand the tradeoffs we’re making as part of our financial planning and will want to marry the benefit of a human advisor who can coach us through our personal needs with a more customized investment plan.”
Michael Kitces, partner and the director of research for Pinnacle Advisory Group and a thought leader on the topic of robo-advising (he appears to be among the first to use the term, in a 2012 blog post on the topic) argues that one of the primary advantages of a human advisor is their ability to deal more effectively with a human client. But technology-augmented advice, or what Kitces terms “cyborg” advising, may be the most significant market change brought about by the robo-advising movement. Improved quality of automated advising tools helps companies offer higher quality (or lower cost) advising services.
Robos may also help drive down the cost of technology currently used by advisors. In fact, Kitces sees a distinct possibility that today's robo firms may realize that the market for providing automated investment services directly to advisors is a better business model than providing this service directly to consumers. The pricing of many advisor technology services suggests that this is a marketplace primed for disruption.
In-person advice may not be immune from competition by robo-advisors. Kitces also points out that the ability to anticipate an emotional client response and to guide behavior toward desired outcomes doesn't require the input of a human. I have a difficult time getting motivated to exercise every day, but my smartwatch reminds me to get off the couch to reach my daily step goal.
In fact, my smartwatch is even more effective than my doctor who I only see once a year. It's possible that a creative robo will develop tools that provide the instantaneous feedback we all need to help guide our daily financial decisions in order to meet long-term goals.
Technology seems to replace services when the human element isn't that important. What did a travel agent do that I can't do myself more efficiently online? But for more advanced professions that require a breadth of knowledge and sensitivity to clients, like medicine or design, the impact of technology will likely be to improve the quality of that service and to reduce costs for the most price-sensitive clients with modest needs. It may also mean that advisors need to be able to better articulate their value beyond the investment portfolio, which is a challenge that we should all embrace.