Industry Report: Robo-Advisors

The threat from independent robo-advisors has been successfully countered so far by the traditional incumbents who have retaliated by acquiring or launching robo-advisors of their own and expediting their efforts to embrace this new technology to grow.

Independent robo-advisors are under increasing pressure to diversify their offerings and add other high-touch, high-margin services in order to survive, as the big banks like Wells Fargo, Morgan Stanley and HSBC are all launching robo-advisory services of their own.

Several high profile independent robos that tried to make niche plays have shuttered in 2018. And there is increasing regulatory pressure. The SEC has taken its first major regulatory actions in December 2018 against robo-advisors in an effort to crack down on misleading information and false advertising.

With the re-emergence of volatility in financial markets, robo-advisors will be tested for the first time in the coming months in a bear market and their ability to navigate this volatility well will determine how fast they’ll able to evolve and grow.

In this overview of the automated advisory services, we take a look at this market segment’s evolution, predominant business model as well as the most promising technology and investment opportunities.

The Big Picture

Automated portfolio managers or so-called robo-advisors have gained prominence in the past decade, promising a low-cost approach to wealth management through a combination of passive investing strategies and algorithmic risk modelling.

While the number of robo-advisors has grown significantly, predominantly centered in the US and Europe, they still represent a miniscule fraction of the overall advisor market. As of 2018, the the global RIA (Registered Investment Advisor) market size (measured as Assets under Management (AUM)) is estimated to be about $82.5 trillion. This is up 16.7 percent from the $70.7 trillion recorded in 2017 primarily driven by rising asset prices as the financial markets continued to stay frothy. In contrast, the Robo-Advisor market size as of 2018 was around $397 billion, an eye-watering growth rate of 63% YOY.

The launch of independent robo-advisors like Betterment and Wealthfront in 2008 signalled a major disruption in the wealth management industry and since then, the incumbents like Vanguard Charles Schwab, Fidelity and E-Trade have responded to meet the challenge by launching robo-advisory services of their own. According to a comprehensive report from Barrons in 2018, “Vanguard was the industry leader with $112 billion in assets in its automated product. Charles Schwab was No. 2 with $33 billion. Betterment still leads the independent players, with an asset base of $14.5 billion across 375,000 customers. Wealthfront is further behind at $11 billion.”

The aggressive response from the incumbents in the space has thrown open questions about the future viability of independent robo-advisors. Many of the independent robo-advisors have adapted by layering in human advisors and diversifying the services they offer, but it is unclear if that would be enough for them to continue to thrive. There have been some high profile closures of independent robo-advisors and the SEC has stepped in to discipline some wayward players. The re-emergence of volatility in financial markets amid fears of a China led global slowdown have resurfaced fears that robo-advisors would underperform in a sustained bear market and also exacerbate market volatility.

The Promise of Robo-Advisors : The Business Model

Traditional wealth managers operate by offering clients a consultation with a financial advisor to discuss their financial goals that could include everything from investment goals, college planning and retirement planning.

The financial advisor then puts together a portfolio of stocks, bonds, REITs and other financial assets based on the investors’ age, income, investment time horizon and risk appetite that would achieve the stated investment goals. The wealth manager actively manages this portfolio by rebalancing the various asset classes in the portfolio from time to time to keep the portfolio in line with the investment goals. The wealth manager also manages the portfolio in a tax-advantaged manner (i.e. keep the investor’ tax liability as low as possible).

In return, the wealth manager charges a management fee usually assessed as a percentage of Assets under Management (AUM). The industry standard for traditional wealth managers is around 2% -3%, while most players offer significant discounts on management fees on larger accounts.

In a passively managed portfolio that follows a index tracking strategy using low-cost ETFs (fees range between 0.04% to 0.15% on popular liquid ETFs), the average cost to put together a portfolio is fairly low. For instance, Betterment, a popular robo-advisor that utilizes low-cost Vanguard ETFs to form the portfolio has an average cost is around 0.07%.

The difference between the management fee that the wealth manager charges and the cost of buying the portfolio is the spread that is pocketed by the service provider.

For a traditional wealth manager, who charges around 2% of AUM as a management fee, the spread is quite significant, particularly given the effects of compounding returns over time. Traditional wealth managers have significant overhead costs including staffing physical locations with trained and well-compensated financial advisors to service accounts. In addition if the account is actively managed, that increases the costs of servicing the account. For the fees generated from the account to compensate for the costs accrued in managing the account, traditional wealth managers can profitably serve only accounts with significantly high account balances.

In contrast, robo-advisors rely on a combination of passive index tracking investment strategies and algorithms to derive the optimal portfolio for each investor. Instead of a highly paid human advisor discerning the risk appetite of each individual investor, robo-advice platforms automate the process by algorithmically determining the right portfolio. This allows them to keep management costs low and maintain profitability even as the spread is narrowed. Furthermore, by eliminating the high account minimum barriers, robo-advice platforms are able to bring in a small retail investors into the fold. The crucial difference between these business models is quite simple. Traditional wealth management is a high margin - low volume model, while robo-advice platforms are making a low margin- high volume play.

The Evolution of Robo-Advisors

Robo-advisors have evolved quite significantly over time and tracing this evolution give us an indication for the future course of this industry. Robo-advisors started off with a bare-bones risk appetite questionnaire and used that to put-together a tailored portfolio of securities (mostly low-cost ETFs), with the portfolio managed manually by dedicated investment managers. This has slowly given way to portfolio rebalancing driven by algorithm based adjustments that are governed by some predefined investment rules and passively overseen by fund managers with manual intervention kept to a minimum.

There are three principal reasons why robo-advisors have taken off:

* They are inexpensive: The trend toward passive investing and cheap funds is still quite strong. Robo-advisors are significantly cheaper than traditional wealth advisors. Irrespective of whether it’s a robo-advisor managed by a large incumbent like Vanguard or an independent player like Betterment, the fees are very low considering the professional grade services offered.

* There are no/low account minimums: One of the biggest barriers for small retail investors from accessing wealth management services is the substantial upfront commitment to open an account. Platforms like Betterment are essentially democratizing the wealth management industry by bringing in a lot more people into the fold by dismantling these barriers to entry.

* Ease of use and fiduciary: These platforms with their passive index tracking investment strategies make investing simple. Users can set up a recurring deposit on payday and everything else is managed for them and that’s quite a significant advantage over the traditional model of trying to navigate the thicket of financial jargon with a financial advisor who might not always act as a fiduciary.

Given these advantages and the enthusiastic response from consumers, independent robo-advisors like Betterment and Wealthfront have also forced the traditional players to adapt and launch/ acquire robo-advisory services of their own. In 2013, Goldman Sachs lead a $25 M Series C investment round in the robo-advisor, Motif. In 2014, Fidelity invested in Future Advisor. Since 2015, Charles Schwab launched Schwab Intelligent Portfolios, Northwestern Mutual acquired Learnvest and Vanguard debuted Vanguard Personal Advisor Services.

The disruptors have also been forced to forgo a digital only strategy and begin to bring in humans into their service as part of a premium offering. Most of the robo-advising industry has now adopted a hybrid approach with human financial advisors supplementing the robo-advisor component of the service.

Another innovation has been the launch of Betterment for Advisors, which allows financial advisors to use the platform to open accounts for clients and automate the operational side of the business offering everything from automated billing to accounting and tax services. The play seems to be to pitch Betterment as a tech service that manages the back-end of the traditional financial advisory business instead of replacing human financial advisors, who are in-turn freed up to provide other high-touch services like financial planning etc. Wealthsimple, the largest of the Canadian independent robos has also launched a similar service, Wealthsimple for Advisors.

While initially, financial advisors who used this platform were restricted to the core portfolio of low-cost (mostly Vanguard) ETFs, Betterment launched a new product called Flexible Portfolio in May 2018 that allows financial advisors to get more granular control over the weights assigned to different asset classes. It also has expanded the available asset classes to REITs and high-yield corporate bonds.

The Challenges for Independent Robo-Advisors

One often overlooked advantage that traditional wealth managers like Vanguard have is that not only can they pocket the robo-advisory management fees, they also collect the fees from purchasing the underlying low cost ETFs that go into these portfolios. Independent robo-advisors like Wealthfront form their portfolios by putting together low-cost ETFs purchased from big brokerages like Vanguard and Charles Schwab. That difference would add up quite significantly over the long-term. For instance, consider Vanguard’ robo-advisor Personal Advisory Services (PAS), which charges a management fee of 0.30% of AUM relative to Betterment’ 0.25% of AUM. The average Betterment portfolio composed of low-cost Vanguard ETFs costs about 9 bps (+/- 2 bps based on the weighing scheme and portfolio composition), so the effective fee paid by Betterment’ customers is 34 bps of which Betterment pockets 25 bps and forks over 9 bps to Vanguard. For servicing exactly the same portfolio, Vanguard earns 30 bps as the management fee, but crucially also pockets the 9 bps it costs to buy that portfolio, effectively earning 39 bps. That spread of 14 bps could be quite significant, particularly for long- term accounts.

Further, Independent robo-advisors like Betterment have low or no account minimums for opening an account. The no/low account minimums allows small retail investors to gain access to professional-grade investment services that allow them to invest in a well-diversified portfolio. In contrast, Vanguard, the largest incumbent in the space requires a minimum investment of $50,000 in order to qualify for its robo-advice platform, Personal Advisor Services. Now, there is no reason why Vanguard can’t lower the entry requirements to lower levels to hoover up these small investors. However, the high account minimums mean that the accounts start generating significant fees right from the start, which would only accelerate over time as the account gets bigger.

Wealthfront, the second biggest independent robo-advisor already appears to be in trouble. In 2014, they raised $64.17 M in Series F VC funding at a pre-money valuation of $635.83 M. However, in Jan 2018, they managed to raise $75 M in Series G funding at a pre-money valuation of only $425 M. While Betterment and most other robo-advisors have started to layer in human advisors into the business and move into a hybrid model, Wealthfront has adamantly stuck to its pure-robo model. It has also not tried to make a play for the RIA market like Betterment and ceded ground there as well.

In December 2018, the SEC charged two robo-advisors, Wealthfront and Hedgeable with “making false statements about investment products and publishing misleading advertising.”, marking the first move by the market regulators against robo-advisors. Wealthfront agreed to settle the charge that it made false statements about the much touted tax-loss harvesting feature by agreeing to pay a fine of $250,000 without admitting or denying any wrongdoing. Hedgeable, which had earlier in the year announced its closure, agreed to pay a fine of $80,000 to settle charges that it made false claims about the performance numbers posted on the company website and social media.

In the last year, several robo-advisors and financial planning platforms have shuttered, most notably Hedgeable and Learnvest. Northwestern Mutual, the insurance giant that paid $ 250 million to acquire Learnvest in 2015 wound down the financial planning platform and announced that it would be relaunched as a financial education platform. Two women-focussed robos, WorthFM and SheCapital also shuttered, while another women-focussed robo Ellevest appears to be tethering with only $91.4 million AUM across 12,000 odd accounts.

In other news, Betterment announced in December 2018 that it was launching a new tool that would monitor the linked bank accounts of its users and “sweep any excess funds” into a low-risk ETF portfolio that generates returns of about 2%. The tool also promises to liquidate the portfolio and return the funds as cash if the linked checking account falls below one-month worth of estimated expenses. While the idea is novel, It remains to be seen how wary investors would be about transferring “excess cash” from a FDIC insured bank account into a money market account.

In December 2018, Wealthfront opened up its automated financial planning tool as a free service to any users who download the Wealthfront app in an effort to expand their user base and diversify the services they offer.

Major banks are getting into the act as well. In November 2017, Well Fargo launched its hybrid robo-platform called Intuitive Investor developed in partnership with the fintech SigFig. Morgan Stanley followed suit by launching their robo platform, Access Investing in March 2018. In October 2018, HSBC announced the rollout of its robo-advisory offering called “Wealth Track” in partnership with Marstone, a wealth management software startup.

Roadmap for the Future

While independent robo-advisors have certainly democratized the wealth management business, several key concerns persist about the their future viability. For one, the incumbents like Vanguard have forced independent robos to adopt a hybrid approach of layering in human advisors to complement their robo platform, straining the already slim margins they had to contend with. This dynamic has signalled the death knell for some independent robos and it remains to be seen how the rest adapt to this shifting dynamic.

One potential solution is to to diversify their offerings and that trend is starting to emerge as demonstrated by the Wealthfront CEO, Andy Rachleff’s statement that “ [the] vision is to deliver a service where you direct deposit your paycheck and we automatically pay your bills, automatically top off the emergency funds and then route money to any investing platforms that meet your goals.” Other competitors are following suit with micro-savings robo Acorns launching a whole raft of products ranging from checking accounts to retirement accounts. A second potential solution to address the business model challenges would be to adopt a “freemium” model centered around a low-fee robo-advisory platform but complemented by other high-touch high-margin financial services like insurance, college planning and estate planning etc.

Another interesting possibility to watch for in this space is the incorporation of AI and Machine Learning techniques that could usher in a future of fully-automated investments, asset class shifts and rotations based on evolving market and macroeconomic conditions. The logical future for the industry could perhaps be self-learning algorithms training on the vast amounts of financial data being churned every day and making completely automated portfolio allocation decisions without any pre-defined investment rule sets.

A crucial criticism of the close embrace by market participants of the passive investing trend in general and robo-advisors in particular is that these strategies are untested in a downturn. The recent resurgence of volatility in the financial markets and the probability of an impending recession inching higher, the stage is set to answer this question. Robo-advisors with their emphasis on matching market returns might prove to be significant laggards in a bear market, but that remains to be seen.

Finally, the larger question remains as to whether the trend toward passive investing spearheaded by the robo-advisory business could weaken market disciplinary forces. Embedded within the free market system is the idea that active traders in financial markets reign in asset prices and prevent them from drifting too far from fundamentals. One interesting thesis to consider here would be whether the increasing emphasis on passive investing could introduce arbitrage opportunities for active investors when security prices trade away from fundamentals.

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