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Robo-Advisors: An immediate threat?

 6 min read / 

In the US, around 200 robo-advice firms manage approximately $19bn in assets, with some of the larger corporations like Wealthfront and Betterment managing over $2.5bn. The UK market is small by comparison, with the largest robo-advice firm, Nutmeg, handling just 55,000 accounts. However, recently there have been some significant acquisitions in robo-advice technology by UK market leaders. Last year, Schroders invested in Nutmeg and this year BlackRock acquired FutureAdvisor and Aberdeen Asset Management bought Parmenion Capital Partners. In light of the expanding UK market, the FCA recently discussed the impact robo-advisors could have on the future of financial advisory firms. The general consensus is that automated services will not replace human advisors even in the long term, but advisory and investment firms need to actively consider the technology as tech savvy millennials begin to gain investible wealth in the coming years. In the short term, the technology will be beneficial for client segregation, reserving the more expensive services of human financial advisors for high net worth investors and large institutional clients whilst also offering a service for smaller, younger investors – attracting a more diverse client base. However, it is widely thought that the day of reckoning will come when we enter a bear market and robots have to persuade investors not to panic whilst effectively shielding their invested money from significant losses.

Strengths

Financial advisory and asset management are industries that have largely avoided the recent fee compression that has affected areas like investment banking. The low cost offerings of robo-advisors contrast significantly with the 2% frequently charged by human advisors. Charles Schwab and WealthFront are amongst those offering a range of services free of charge, with the majority charging still comparatively low fees in the region of 0.25% to 0.5%. These cheap products will undoubtedly put pressure on professionals to demonstrate how their services, such as active management, add value and justify the proportionally higher fees. If the passive portfolios constructed by robo-advisors are successful enough, they could seriously threaten the popularity of ETFs offered by traditional managers. The entrance of robo-advisors into the market will provide additional competition that can only be good for investors – they will have more choice of investment method and those opting for human advisors will receive a better service at a more competitive cost. As Cullen Roche from Pragmatic Capitalism stated:

“I think the Robo-Advisor phenomenon is a positive industry disruption that will ultimately push down fees, push out weak advisors”

Financial advisors’ clients are mainly baby boomers, and the industry has been criticized for doing little to attract the next generation of investors. Millennials grew up during the global financial crisis and experienced the subsequent disillusionment and distrust of financial services. Crucially, they have also seen countless human services automated – Netflix replaced Blockbuster, Instagram replaced Kodak. Robo-advisory offers the easy, instant service (often in the form of mobile apps), they are used to. The demographic of robo-advisory clients demonstrates the younger generations’ inclination towards automation. Betterment’s average customer is a professional in their thirties, and 75% of the cliental is under 50 years old. Similarly, 90% of WealthFront’s investors are under 50, and 60% are under 35. A couple of years ago, the only option for these young, low value investors would have been DIY investing – stock picking their own investments – something that can often end badly. Amateur investors are guilty of buying at the top of the market and selling at the bottom, and frequently anchor to an arbitrary stock price with little regard for underlying asset value. They can be driven by fear of regret and are liable to sunk cost accounting. Could robo-advisory save them from themselves? As Red Adair once asserted:

“If you think it’s expensive to hire a professional to do the job, wait until you hire an amateur.”

Limitations

A common argument against the software is its inability to be utilized by all types of investor. For investing small amounts, efficiency and low costs will force many to question the worth of a human financial advisor. As Conor Sen, a former hedge fund analyst now working for a FinTech startup, succinctly argued: “Why would doing anything alternative beat a low cost algorithmic asset allocation program?” However, it is likely that high net worth individuals and large institutional investors will always regard the charges of human advisors as offset by the added security, understanding, experience and skill that the service provides. A good example is the understanding of risk tolerance. Most robo-services determine risk perception and financial goals from a few questions upon setting up an account, an infinitely less nuanced understanding than that created through a relationship with a human advisor. With tolerance of risk changing constantly, those with large sums of money invested, whether it be their own or on behalf of others, may find the less robo-advice unsuitable.

Robo-advisors claim to prevent exoduses from markets during downturns that amateur advisors would overreact to. However, this is based on an assumption that all investors would willingly take advice from a robot. If investors saw the value of their portfolios diminishing would they remain in the market on the advice of a robot in tweet or email form? Robo-advice has developed during a bull market, so by relying upon available historical data and past volatility (from a bull market), they could direct investors to overvalued industries and could see services could falter if we enter a bear market. Are investors only willing to trust investing based on passive funds and ETFs when markets are optimistic? When markets fall, the appeal of human and active management may become more favourable. Additionally, robo-advisors will fail to spot black swan events and market movements associated with illogical behaviour – missing both unpredicted opportunities to maximise returns but also instances when money could be lost rapidly.

The future?

Various surveys conducted this year revealed high predictions of the future robo-advice market. AT Kearney predicted the US market to be $2.2 trillion by the end of 2020 and Citi suggested the global market could be anything up to $5 trillion in the next 5 to 10 years. It is clear that robo-advice will take a large market share, and will bring some beneficial changes to advisory and investment management. Short-term client segregation will be greatly aided, attracting younger, tech savvy and price sensitive generations to financial advisory and enabling them to begin small scale investing, before they become the high net worth clients of the future. Longer term, more people will be reluctant to give up the slickness and ease of technology, prompting advisors to form ‘hybrid’ models – using software to compliment their traditional services. Even though more established advisory companies are less likely to be seriously threatened, as are services for institutional and high net worth clients, they will need to incorporate the services into their client offerings in order to remain current and innovative. The recent popularity of robo-advisors may falter when we enter a bear market, and time will reveal whether investors seek the assurance of active management based on human judgment and algorithmic analysis in favour of automation.

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