If an investor regularly chooses the self-checkout line in the grocery store, orders take-out online, or never steps foot inside a bank branch, a new breed of wealth management adviser may suit his lifestyle perfectly. These services ask the investor a series of questions about financial goals, risk tolerance, and investment horizon and then pick suitable, diversified investments for the investor’s portfolio. They even automatically rebalance the portfolio’s asset allocation when it starts to drift from the original model. And they do it cheaply.
These advisers are not people, of course. They’re computer algorithms, or “robo-advisers,” and they’re revolutionizing the construction of low-cost investing portfolios for large swaths of investors.
Judging from early adoption levels, such automated online financial advisers will manage about $2.2 trillion in assets by 2020, or as much as 10 times the amount of their current assets under management, according to management consulting firm A.T. Kearney.
Robo-advisers are also growing and changing rapidly, and analysts predict they will play an ever-increasing role not only in the investment portfolios of retail investors, but also in companies’ defined contribution retirement plans — the first place a CFO is likely to encounter them.
For the investor, the appeal of robo-advisers — also known as digital wealth management or digital advice solutions — is their low fees relative to human advisers. Charges range from 20 basis points of assets per year for the most aggressively priced services to 90 bps for services that combine both human and robo-advisers. That compares favorably with the 100 bps to 200 bps that human wealth managers charge.
But low costs are not the only appeal of robo-advisers; they can also make financial planning pleasant. “The start-up firms that have come out have designed a terrific user experience that’s intuitive and easy to grasp,” says Brent Beardsley, global leader of Boston Consulting Group’s wealth and asset management area. “They’ve approached it very much from a consumer mindset, which helps demystify the whole thing for retail investors.”
“It’s a great experience now,” says Gauthier Vincent, lead wealth management consulting partner at Deloitte. “It’s very engaging. Instead of ‘Aargh, I have to answer these 20 questions,’ now I want to answer them because it’s part of the experience.”
Robo-advisers have also evolved from their roots, which consisted of just providing automated portfolio construction and asset allocation. Now, they automate a wider financial planning process, asking clients questions about financial goals — funding college, buying a second home, or caring for elderly parents, for example — and building client profiles based on an individual’s preferences and risk tolerances. They also recommend specific investment products and invest in them on the client’s behalf. “Now, it’s not only digital, but there’s a lot of science to it,” Vincent says. “Ask a few questions, start giving advice immediately, then ask more questions, then there’s a dialogue.”
Robo-advisers typically invest on behalf of their clients in a basket of low-cost exchange-traded funds based on the portfolio models they generate for the individual’s circumstances — balancing between equities and fixed income, domestic and non-U.S. instruments, and other measures of diversification. Then they monitor and rebalance the portfolio, typically once per quarter.
Most robo-advice firms target the mass affluent — those with $100,000 to $1 million in liquid financial assets. (Some investors with larger balance sheets are automating small pieces of their portfolios this way.) Currently, robo-advisers follow three general service models, says Vincent: The self-guided investor-centric model, where a human may be available for technical support; the hybrid model, in which the human adviser takes the lead and uses the robo-adviser as a tool; and a split hybrid model, in which the investor can choose either the human or robo-adviser, and then switch between the two as needed.
Based on consumer surveys, experts predict that in about five years the various models will converge into a common hybrid model in which a digital interface provides advice along with the backing of a human, says Uday Singh, a partner in the financial institutions practice of A.T. Kearney.
Investment performance, the theory goes, could at some point become much less of a differentiating factor between robo-advisers—because of their widespread use of low-cost passive investments, such as ETFs, returns will tend to be about the same. Instead, customers will make their choice based on the experiences offered by the various platforms.
“The current situation in banking could be an analogy,” Singh says. “Whether you go to Chase or SunTrust, you’re basically going to get the same interest rate on your deposit. But you will make a choice on which one to bank with based upon proximity to a branch, or the features and functionality of the digital offering. The future of investing could well move in that direction, and could become a lot more about the investor’s experience, if returns tend to converge across all platforms.”
The Rush to Automate
Robo-advisers started from standalone, venture capital–funded startups as many as six years ago, and they pitched straight to consumers. Personal Capital and Betterment were two of the leading platforms in the category. Then, about three years ago, some of the other standalones, such as SigFig and FutureAdvisor, pivoted to developing white-label products in partnership with financial advisory and wealth management firms.
Recently, robo-advisers built by large wealth management firms have been raking in assets. Vanguard gathered $30 billion for its robo service in nine months, and Charles Schwab’s Intelligent Portfolios robo-adviser was the biggest offering in the market — bigger than the standalones — within 12 months of launching. E-Trade and Fidelity also have leading robo offerings.
In the last 12 months, every major wealth manager that doesn’t yet offer robo-advising has begun either planning a product or looking for a white-label partner. Merrill Lynch, for example, is building a robo platform to launch in 2017. Wells Fargo, UBS, and BBVA all have robo-advisories in the works. “In next 5 to 10 years, every single wealth manager on the planet will have a digital offering,” says Beardsley.
Incumbent asset managers have a massive advantage, he adds. “They have a brand, they have an existing customer base, and they have a whole bunch of distribution advantages that the startups can’t duplicate. The whole notion of customer acquisition is the hardest thing for a start-up to get.”
In the competition for customers, standalone robo-advisers like Betterment and Wealthfront face a challenge in building their assets under management to the point where they will be profitable, says Michael Wong, an equity analyst at Morningstar. To compete with the established brokerages that offer robo-advising services, the standalones will either have to grow to a profitable scale through mergers or spend heavily on advertising and marketing to recruit customers.
The first time CFOs may encounter robo-advisers will probably be in the workplace — in retirement plan services for employees. Employers can now offer workers robo-services related to 529 college savings accounts or 403(b) and 401(k) retirement savings. Betterment started offering robo services for the corporate 401(k) market about 18 months ago, focusing on smaller 401(k)s so it wouldn’t have to compete directly with Fidelity-sized players.
Betterment’s management fees range from 10 basis points for the largest employers with more than $1 billion in total assets to 60 basis points for the smallest employers. The employer can either pay the fee or pass it on to its 401(k) account holders.
Blooom is another robo-adviser focusing on the corporate market, offering management of 401(k)s and 403(b) plans. It charges a flat per account monthly fee of $5 for balances under $20,000, $19 for balances of $20,000 to $50,000, and $99 for balances of more than $500,000.
As more CFOs worry about the financial wellness of their employees, which can be a factor in employee productivity and retaining talent, a robo-adviser can be an appealing feature, Singh says.
“To most people, the number of choices within a 401(k) offering is long and confusing, and frankly, investment professionals would have trouble sorting them out,” says Singh. “For CFOs who run large companies and have employee bases with differing levels of financial interest and aptitude, providing those employees with the right tools is going to be important, as will making sure employee interests are kept in mind.”
As robo-advising evolves, not only will the 401(k) investment process become increasingly automated, but so will advice in related financial realms. For example, when an employee is planning how to care for elderly parents, a robo-adviser will be able to help him or her weigh financial management choices in concert with choices for health care and insurance. Or when a worker is planning to retire, a robo-adviser might help him navigate his choice of places to live, factoring in home prices, leisure activities, and health-care facilities.
“We need more and more advice across multiple fields, and as advice is being automated in each of those fields, it’s incredibly easy to integrate advice across them,” Vincent says. “And this is where we are headed.”
Another driver in the development of robo-advisers will be the application of machine learning, in which data about the investor will be integrated with information accessed from outside sources like social media. By tracking a client’s online activities (with permission) — chats with friends, searches, viewing habits, buying habits — a robo-adviser could develop a more granular profile of what makes the investor tick and further tailor investment offerings, as well as manage risk better.
“The more a system can interact with the investor, and learn about the investor interacting with other people, and other providers, the more the system can do,” Vincent says. “Between cognitive computing and machine learning, I think this is going to turbocharge what we see today as robo advice.”
A Human Touch
Human wealth advisers will continue to be valued, of course, especially in financial planning decisions that can be highly emotional, such as choosing what to do during a major market downturn; providing for a disabled child who can’t support himself; or planning to pass on wealth to the next generation when the children aren’t on good terms with the parents, Vincent says.
“The time when an investor would pay 100 or 150 basis points to sit down with an adviser once a year is gone, because there’s not enough value in that,” he explains. But for more complex situations, an investor might willingly pay that fee.
In some cases, human advisers can also help clients talk through their life goals and risk tolerances better than a robo-adviser. “You could automate some of those questions, but a person who’s just starting their professional life is going to have a hard time even thinking through those issues,” Beardsley says. “You really need a human in the relationship to do that.”
For market corrections, analysts debate whether human financial advisers are better suited for helping with decisions — and maintaining calm — than robo-advisers. Because investors as a whole tend to panic in a market downturn, robo-advisers are at a disadvantage, says Singh: Clients who panic can easily get on their laptops and sell during a correction, typically the worst time to liquidate.
But human advisers, in the same situation, can provide “that emotional blanket,” he says. “They say: ‘Yes, things look bad today, but in the future they will look better, so just hang on and you’ll be OK.’” A human adviser “removes the ingrained behavior that we’ve seen over time, where casual investors tend to buy high and sell low, and therefore depress their returns,” says Singh.
But one robo-adviser actually gained assets following a market correction in October 2015, in part because of tailored emails it sent out to clients as soon as the markets started to move. The emails explained to investors why their investment allocations were still sound and why they should stick to them, or how the robo-adviser had already rebalanced the portfolio, Vincent says.
“When the market is moving, I want my adviser to talk to me in real time. Is it possible for a real adviser, a human being, to pick up the phone and call his more than 200 clients within a half hour? No, it’s impossible,” he says. “So in a sense, the machine is much more human, because it treats the investors as they want to be treated: as human beings, that is, in real time.”
A Boost from the Fiduciary Rule?
Robo-advising may be the only economical way to serve small-balance accountholders.
One factor that could give a big boost to the robo-advisory business is the new U.S. Department of Labor fiduciary rule, which goes into effect in April 2017.
The rule expands the “investment advice fiduciary” definition under the Employee Retirement Income Security Act of 1974. The new rule requires all investment advisers, including brokerages, to act as fiduciaries when making recommendations or giving advice on 401(k) plans or individual retirement accounts (IRAs), including in instances of a rollover or distribution.
The DoL rule also prohibits financial advisers from earning certain kinds of commissions for transactions with a retirement account. To do that, the transaction has to qualify as a “best interest contract exemption.” To qualify for the exemption, the adviser must agree in the contract to acknowledge its fiduciary status, disclose potential conflicts of interest and information about its revenue model, give prudent and impartial advice, and avoid misleading statements.
Besides putting a crimp in commissions-based investment advice, the new DoL rule will cause investment managers to move their customers with small account balances to robo-advisers, experts say. That’s partly because the investment needs of those clients are not that complex, and the business models for most financial advisers under the new fiduciary restrictions won’t work with small account balances.
But the fiduciary rule presents a problem for robo-advisers as well, because it may make it harder for pure robo-advisors to qualify as a fiduciary. The Massachusetts Securities Division ruled in April, for example, that it would evaluate whether robo-advisers can be fiduciaries on a case-by-case basis. The state’s securities regulator, William Galvin, said that “entities that create computer-generated portfolios but fail to do the necessary customer due diligence to know their customers and who specifically decline most if not all the fiduciary duty are not performing the duties of investment advisers.”
The Massachusetts policy applies to “fully automated” robo-advisers “devoid of all human services.” — KB