The recent BlackRock purchase of FutureAdvisor pushed robo advisors to the front page of the business section. But What’s Next? We lay out our predictions for the future of robo advisors. We identify a couple of losers and winners based on current trends we see in the market:
  • Big Loser: Inefficient traditional advisors
  • Potential Loser: Undifferentiated robo-advisors (e.g., passive buy-and-hold)
  • Potential Winner: Differentiated robo-advisors (e.g., affordable active portfolios)
  • Big Winner: Consumers of financial services

Big Loser: Inefficient traditional advisors

Traditional advisors can be worth their weight in gold for one simple reason: advisors save us from ourselves. Advisors are the much needed psychology coach that keeps us from jumping off the cliff when the market tanks. They also prevent us from doubling down on stocks and mortgaging our home at a market peak. In short, good advisors help us minimize our own behavioral bias. Good advisors, providing genuine psychology coach benefits, should be largely insulated from the robo revolution. Clients will gripe about fees, but human to human interaction will maintain its value to the extent that robo-advisors are unable to serve as psychology coaches. So chalk one up for the humans. But simply being a human being is not going to be enough for advisors in the future. Traditional advisors should still be terrified of robo-advisors. One particular class of advisor should be worried the most: Sloth-o-saurus. Slothosaurus is a unique advisor phenomenon. A product of the good old days (5% commissions, 2% management fees, hatred of all things tech), the Slothosaurus accumulated assets in an earlier time (less competition, more ignorance, fatter margins). Slothosaurus considers their edge to be “great relationships.” Slothosaurus often loves great relationships for the wrong reasons: for the Slothosaurus, the goal of the relationship is not to maximize client value, but to create client “stickiness,” and an ongoing revenue stream. Sadly, Slothosaurus faces a problem when clients pass wealth onto their future generations–the kids don’t value these “relationships” and they hate being stuck in a win-lose situation. They bolt for a lower cost, more transparent, more proactive advisor that actually has a value-proposition beyond “paid friend.” Robo-advisors will accelerate the demise of this species. Slothosaurus advisors that are not evolving, innovating, or embracing technology to enhance value for their clients, will quickly go extinct.

Potential Loser: Undifferentiated robo-advisors

Passive portfolios are a commodity product–any investor can buy a basket of low-cost tax-efficient index ETFs via their personal brokerage account. Moreover, recent research shows that how one puts these products together is somewhat irrelevant. In expectation, there is little difference between one fancy asset allocation model and another. In fact, asset allocation models that equally-weight assets, typically meet–or beat–the performance of complex approaches. So where does that leave the current group of robo-advisors? Unfortunately, the typical robo-advisor offering is a commodity: a passive portfolio that follows a generic allocation algorithm (e.g., mean variance analysis). And to make matters worse, the newest robo-advisors aren’t making the underlying commodity (i.e., the underlying funds). In many respects, generic robo-advisors are just adding a layer of expenses on top of underlying commodity products. Typically, the winner in this sort of market goes to the producer with extreme operational efficiency and economies of scale. In other words, firms like Vanguard, which manufacture the underlying products and have scale, or firms like Charles Schwab, which manufacture product, generate distribution fees, and have scale. These older firms, not the newer breed of robos, are the natural winners in this race. Playing the tape forward, generic robo-advisor services will be free, and robo-advisor economics will be tied to the underlying investment products and distribution fees–not the asset allocation service. We see this race to the bottom in realtime: Wealthfront is lowering their minimums/costs, Wise Banyan dropped their fee altogether, and Schwab’s Intelligent Advisors service is free. Of those three players, only one can make money when the robo-advisory service is free–Schwab! So now we can begin to see why Blackrock might be interested in acquiring a robo-advisor: they can offer the advisory service for free and still realize profits from the underlying products being distributed. So let’s recap: Commodity product offering; low barriers to entry; and downward pricing pressures from Vanguard and Schwab. The robo-advisor movement is here to stay, but without a differentiated product offering, an amazing brand, or a unique business model, running a profitable passive allocation robo-advisor appears challenging.

Potential Winner: Differentiated robo-advisors

A big problem with financial services is the distribution challenge–how do you get your product to market? The typical approach involves leveraging a bank’s foot soldiers or partnering with a broker in a pay-to-play arrangement. The distribution challenge creates a problem: good ideas and strategies are unable to get to market because the intermediary channel can’t maximize profits. Sometimes the best investment strategies are even effectively blocked by the intermediaries when they are unable to skim profits for themselves (think wirehouse “platforms”). A potential solution: disintermediate financial services! Fortunately, improved investor education, cloud-based advisor technologies, and smart social media marketing efforts, are facilitating the disintermediation revolution. And that’s why we love the robo-advisor concept. Any asset manager, advisor, or innovator can take their idea, leverage technology, and provide a comprehensive direct-to-consumer solution, cutting out the middle man along the way. Moreover, even if you don’t have millions in marketing dollars, your product has an opportunity to sell itself – drumroll please – on merit. So, for those advisors who believe they have a robust process, a quality team, and a value-add service, the robo channel enables him or her to bypass many traditional–and often expensive–distribution channels, and go direct to consumer. The key, of course, is to have a well-defined value proposition, a differentiated product, and a clear market segment. Business school 101.

Big Winner: Consumers of Financial Services

In an era where some Americans’ retirement plans include buying baseball cards and taking a third equity line out against their home, anything that enables individuals to access affordable financial advice is a welcome innovation. The ability to service small accounts with (somewhat) tailored advice is revolutionary. From a traditional advisor’s profitability perspective, the investment management process is labor intensive. Advisers must consult with the client, establish asset allocations, monitor expenses, rebalance periodically, reinvest dividends, manage taxes, and communicate with the client on an ongoing basis. You can make a good case that the same amount of work goes into managing any portfolio, regardless of its size. For example, consider the case of John Doe, a Financial Adviser who is providing investment management services. Let’s say John is sitting in his office one day, and he gets two emails. The first email is from Bill Baby Boomer, who has $1,000,000 to manage, and the second email is from Mark Millennial, who has $10,000 he wants managed. John would like to help both prospective clients, but he has to assess both of these opportunities. Bill’s larger account is pretty easy. John can charge Bill 1.00% on the $1,000,000, which means John will earn $10,000 in fees every year. This compensates him for the time he would spend managing Bill’s portfolio. The situation with Mark’s smaller account is more problematic. If John charges a 1.00% fee on Mark’s portfolio, he will only earn $100. John cannot justify opening an account for Mark, because he can’t cover the fixed costs of his time. For John to justify an advisory relationship with Mark, he would need to charge him upwards of 5%, or perhaps 10% of assets, which would equate to $500 to $1,000/yr in fees, or 1/10 the fees generated by Bill’s account. In effect, Mark’s lack of assets shuts him out of the financial advice market. With robo-advisors, Mark is back in the game. Asset allocation, tax efficiency, and other offerings formerly provided exclusively to high net worth clients can now be provided to all consumers. And, as mentioned above, the all-out slugfest occurring between the big names on price (go as low as possible) and service (provide the best possible) is a win for customers. Because of this, even larger accounts like Bill’s are beginning to pay attention. Robo-advisors are creating a lot of value, but it is the customer that is capturing the lion’s share of it–not the advisors. Unfortunately, businesses that add a lot of value, but are never able to capture any value, tend to have short life-spans. How long can pureplay robo-advisors, whose profitability is based only on the advisory piece, survive against larger players, like BlackRock, who can offer this service for free?

The Machines are Here to Stay: Adapt or Die.

Robos are changing the landscape of financial services and consumers will reap the rewards. But will the computers replace humans? Unlikely. The psychology coach benefit is hard to replicate with a computer. However, robos will encourage human-based advisors to up their game. Slothosaurus will go extinct—thankfully! First iteration passive robo-advisors will create a lot of value for consumers, but capture little value for their VC investors, unless perhaps they are bought out. Finally, differentiated robo advisors and traditional advisors who embrace technology will score big wins for both consumers and their shareholders. Note: Patrick Cleary is a co-author on this piece.
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