Over the past year, the financial advisory world has witnessed the emergence of the ‘robo-advisor,’ technology-driven investment advisory services that substitute ‘expensive’ humans for low-cost, highly scalable software and algorithms that seek to deliver much of what advisors do today with respect to portfolio construction, but at a fraction of the cost.
Underlying the robo-advisor model, though, are insights that are relevant to any financial advisory firm. For instance, the core building blocks of robo-advisors—a systematized investment process, supported by programmed technology automation to implement the portfolio—is not unique to robo-advisors; any advisor can use these tools, and they already exist.
In fact, it turns out that many financial advisors already deliver everything that robo-advisors do, and more. Advisory firms have been increasingly shifting to model-based portfolios for years, and “intelligent” rebalancing software that replicates virtually everything a robo-advisor already does has been around for nearly a decade, as has been shown indirectly by Morningstar’s “gamma” research. So robo-advisors may be less of a threat to traditional advisors than they are an acknowledgement that inefficient advisors who don’t systematize and use technology will be increasingly threatened by those who do, be that advisor robot or technology-augmented human.
The Robo-Advisor Value Prop
One of the key distinctions of the investment offerings provided by robo-advisors like Wealthfront and Betterment is that they have entirely systematized their investment approach. While this doesn’t literally mean that every client will receive the exact same asset allocation and investment holdings, it does mean that every client at a given level of risk and with similar goals will have the exact same asset allocation and investing holdings.
The reason this matters is that a truly consistent and systematic investment process allows for two key efficiencies. First, it allows the firm to focus on a narrower set of investment decisions where small improvements can benefit everyone. Second, consistent portfolios and the technology tools to support them can automate much of the process, bringing a level of proactive efficiency to investment management that simply cannot be achieved on a one-at-a-time, client-by-client basis.
Accordingly, the chart below shows the primary value-adds in percentages, and the additional dollar amount that would be accumulated from a $100,000 starting position over the span of 20 years, that Wealthfront communicates as a part of its marketing.
While some might debate the particular numbers, the essential point is that Wealthfront’s value falls into three primary categories: managing cost (indexing over highest-cost mutual funds) and having a process to come up with the right (optimal) diversified portfolio (via their systematic investment process), automatic rebalancing, and various forms of (automated) systematic tax-sensitive implementation (e.g., loss harvesting).
Systematizing Investments With Model Portfolios
One of the primary reasons that robo-advisors enjoy such efficiencies—and are even capable of automating so much of the trading, rebalancing, and tax-harvesting process in the first place—is that their portfolio design process has been entirely systematized. In practice, many, but certainly not all, advisory firms implement portfolios similarly, though in the advisor context they are typically labeled as ‘model’ portfolios, such that clients are allocated into one of a series of model portfolios based on their goals and risk tolerance.
Creating model portfolios allows firms to focus their research and due diligence process on a narrower range of investments and in turn makes it possible for them to spend more time per investment finding the right/best/ideal solution, whether it’s about getting the lowest cost, best execution, ideal construction of the underlying investment structure,or some other feature.
In essence, having 100 portfolios for 100 clients means 100 sets of investments that require research and monitoring, while having all clients allocated to “just” 5 portfolios allows the firm to reduce its due diligence burden by 95%. In other words, having model portfolios allows the firm to gain the same efficiencies as a robo-advisor to focus on establishing the lowest-cost “most optimal” portfolio for clients.
While advisors historically have defended building a different portfolio for every client under the auspices of “we fully customize our solutions to the unique circumstances of each client,” in the future such an approach will increasingly open up advisors to the criticism that they can’t possibly do an effective job continuously monitoring portfolios and performing appropriate due diligence on client investments the way a robo-advisor can.
In addition, advisors open themselves up to criticism that they should just have a portfolio representing their “best ideas” and strategies, rather than having as many different investment approaches and portfolios as there are clients, which can’t possibly accommodate all their best ideas.
Automating Rebalancing and Tax-Savvy Decisions
Beyond the pure efficiency of investment research and due diligence, though, the real value of adopting model portfolios comes from the ability for advisors, like robo-advisors, to leverage technology for continuous monitoring of portfolios, which simply isn’t possible with the same manner of efficiency when every client has a different portfolio.
In fact, while Wealthfront makes the case that a great deal of its value proposition is tied to its ability to effectively implement its continuous-monitoring automatic-rebalancing and tax-loss harvesting, the reality is that the benefit isn’t actually unique to robo-advisors at all. Technology-driven automatic rebalancing, systematic tax-loss harvesting and tax-aware asset location, have already been available to and implemented by advisors in the form of “intelligent” rebalancing software for a nearly decade now (at least, those advisors who have already implemented model portfolios).
However, actual advisor adoption of these robo-advisor-equivalent tools is still astonishingly low; the latest Financial Planning magazine Advisor Technology survey found that more than 60% of advisors still don’t use any form of rebalancing software, a moderate improvement from the prior year’s 69%. That slow adoption has left the door wide open to a challenge from robo-advisors.
In some cases, the blocking point is that the firm simply hasn’t invested the time and money into rebalancing software. In other cases, the issue is that the firm’s investment process is not systematized and is still different for every client, making efficiency with rebalancing software outright impossible. There are also cases where investment models might exist and the software may have been purchased, but it is not actually being used properly to allow for robo-advisor-like efficiency.
Human Advisors Delivering Robo-Advisor Solutions
While robo-advisors have been hailed as a rising threat to traditional human advisors, the reality is that the robo-advisor’s tools of the trade are not unique to robo-advisors. Those tools include systematic model portfolios that are continuously monitored using technology to take advantage of rebalancing opportunities and tax-loss harvesting, while being implemented with low-cost investments delivered in the form of the ‘optimal’ portfolio matched to the client’s goals and risk tolerance. Instead, they’re simply the outcome of an intersection between a systematic portfolio design process, along with the savvy use of technology to implement those strategies, with tools that already exist.
Accordingly, the reality of the advisory landscape is that many advisors already fully deliver the entire core value proposition of the robo-advisor, and have for years, by implementing a consistent range of model portfolios appropriate for client goals and based on their risk tolerance, implementing with “intelligent” rebalancing and trading tools that allow the portfolio to be continuously monitored, rebalanced as soon as it is appropriate to do so, and managed on a highly tax-sensitive basis proactive tax loss harvesting.
(I’d argue, however, that in today’s tax environment, loss harvesting may be overvalued, or even harmful in some client circumstances!)
Ironically, the Wealthfront robo-advisor value proposition is remarkably similar to the benefits articulated by Morningstar researchers as the “gamma” that human advisors already bring to the table.
Of course, this balance of generating gamma by implementing systematized portfolios while using heavily leveraged technology to automatically rebalance and loss harvest isn’t meant to undermine any of the other value propositions that advisors bring to the table with their financial planning and wealth management services. In fact, it highlights the point that the primary difference in pricing between robo-advisors at 25 bps and the typical advisor at 1% AUM fee may be less about the idea that advisors cost more than robo-advisors. Instead, it may be more about the fact that traditional advisors deliver what robo-advisors more for a commensurate cost.
On the other hand, the robo-advisor trend is commoditizing the core management of a passive strategic diversified portfolio, forcing advisors to ensure that they meet the ‘robo-advisor minimum standard’ while bringing to the table additional value to clients.
Nonetheless, the reality is that even with the available tools, clearly not all advisors are delivering what robo-advisors do today. As noted earlier, only 40% of advisors are using some form of rebalancing software, and many others fail to systematize their investment process into model portfolios that would make rebalancing software feasible and effective in the first place. For those advisors, the robo-advisor is a dangerous and emerging threat, since the robos deliver similar or better solutions at a lower cost, while those advisors have limited capacity to deliver more value-adds since they’re inefficiently delivering their existing investment portfolios.
The fact remains that in today’s environment, nearly all of the solutions that robo-advisors implement can be done by human advisors as well, and have been doing so for nearly a decade. Robo-advisors do have some modest enhancements beyond today’s technology-augmented human advisors. For example, Wealthfront doesn’t just own a large-cap index fund, it actually buys each of the 500 stocks in the S&P 500 in appropriate weights so that it can systematically tax-loss-harvest at the individual stock level. In addition, both Betterment and Wealthfront also aggregate trades across all client accounts, since they also broker the transactions, so that they can do so without any transaction cost to clients.
However, the power for human advisors to compete with robo-advisors lies entirely in the hands of human advisors to systematize their practices and utilize available technology, to deliver virtually everything robo-advisors already do but with more gamma on top of it.