Are You Vulnerable to the Robo-Advisor Threat?

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.

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). 

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.

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.