Rise of The Robo Financial Advisors? by Attain Capital

Forgive us for stealing from the cover of the Economist, but given the topic it seems fitting. Ever since the major technological advancements of the 20th century, there’s been a growing fear that soon enough robots will control the world (cue the Terminator franchise). Fast forward to today, and this fear has creeped into the financial advisor space of all places, with articles using  words and phrases like “afraid” & “risk irrelevancy” to display the attitudes and dangers all advisors face if they don’t adapt to the shifting mentality when it comes to investing. What are we talking about? And what is a robo-advisor anyway?  Why are people supposedly fearing it?

Who are the Robo Financial Advisors?

Just like Amazon.com, Inc. (NASDAQ:AMZN) ruined Borders and the local bookstores, Netflix, Inc. (NASDAQ:NFLX) killed Blockbuster, Facebook Inc (NASDAQ:FB) killed talking to your friends, and Tesla ($TSLA) is trying to disrupt the big auto-makers; the whole idea behind Robo Financial Advisors is to disrupt the financial advisor space with new technology and lower costs:  mainly algorithms instead of advisors; websites instead of branch offices, and automated text messages instead of hour long meetings. A few leaders have emerged so far in the space, with names like Betterment, Wealthfront, and FutureAdvisor, and a quick view of their websites will show essentially the same message:  ditch your father’s golfing buddy and invest like it’s the 21st century, with easy, intuitive tools to set things up and automated processes after that so you don’t have to worry about it. 

Why is Everyone Talking about them Now?

It’s the financial equivalent of booking an Uber on your phone versus standing in the cab line at the hotel. And it’s gone beyond the idea stage to real money. Wealthfront launched in December of 2011 and in those 30 months, they have been grown to $1 Billion in AUM, which is roughly an average growth of 33.3m a month. Betterment is doing well too, with $502 mm in assets under management. As for FutureAdvisor, they now have over $118mm AUM, with only 18 employees.  And the Venture Capital folks are falling all over each other to get in on the game wondering if this is the next Twitter or Facebook or whatever, pumping over a quarter of a billion into the space, and $95 million in just a few weeks earlier this year.

Bo Lu, the CEO of Future Advisor had this to say about the size of the opportunity

“There are 32 million mass-affluent Americans-with assets between $100,000 and $1 million-and only 20 percent have an advisor. Sixty percent of families with more than $1 million in investable assets already work with a financial advisor. Eighty percent of our clients never have had an advisor. No ecosystem has ever served these people. That’s a big gap that’s artificial and made by economics. We want to bring the penetration up to where it is for affluent, and that is a 14-million-household opportunity.”

This strategy has certainly captured the attention of Ron Carson of Carson Wealth Management Group which manages $1.9 Billion. Carson says these robo-advisors are causing him to lose business.

“My margins have shrunk considerably,” he said, “and I’ve got a big business compared to the average size of an RIA.”

Who are the investors interested in this?

The quick answer is anyone who likes twitter better than reading the newspaperanyone who books their dinner reservation via open table instead of calling the restaurant. Their mainly younger generations, but we would guess it’s more their tech saviness instead of their age. The tech savvy and app friendly think, research, and act on most situations vastly different from the past. This is true when it comes to making any financial decision as well. The question boils down to how investors want to interact with their advisors. Would you rather have 24hr access to statements, positions, fees, and other account information on your phone, or a professional who will sit down with you and guide you down an  investment path; which would you choose?

The tech savvy across generations (including the Millenial in our office) would more than likely pick the first option; where older generations might choose the second option; enjoying the relationship and small talk about the house, kids, and dog. From our in house Millenial:  “the last thing anyone I know wants is to have someone call them to small talk. Millennials grew up in an age where they only time they want to talk on the phone with a business is when they’re their complaining about a product or service (while writing a bad review on in the app store, Yelp, Facebook).”

While some advisors believe these robo-advisors are just a fad, in a recent Investment News article appropriately titled, “Why Ron Carson is afraid of robo-advisers,” Carson said he’s afraid of these robo-advisors because of debate over how people want to access their financial resources. 

InvestmentNews: This week at a conference for advisers, you asked people to raise their hands if they were afraid of robo-advisers. By and large, the answer was no: only a handful of people raised their hands. What about you? Are you scared of robo-advisers?

Mr. Carson: Absolutely. It’s a real threat because of the increasing demand and the desire to serve that demand. They’ve attracted a lot of smart money to that industry. And they’re figuring it out. I was at a conference and a couple of advisers sat on stage and they said: “It’s no real threat. These kids, they think they want to use a technology platform. But they’re going to want a human being in the end.

I don’t think so. I mean, on our consumer panel, these young kids said: “I want my information 365 days a year. If it’s 3:30 on Christmas Eve, I want to know how I’m doing. I want the latest information on it.” And most of us are not providing that to them right now.”

Betterment and Wealthfront are appealing to this millennial mentality in which investors don’t want/need to talk on the phone about their financial planning. From the millennials perspective, since these robo-advisors are offering low to no cost ETF products in a 5-year bull market, there hasn’t been a need to talk to human advisor. It’s all been gravy and quite easy during their short tenures. You just buy index tracking ETFs and voila – everyone’s happy.

Is there a problem with this Business Model?

Now, not everyone is buying into this “evolve or risk irrelevancy” claim. Most of the advisors at the conference Carson was speaking at do not foresee these robo financial advisors as a potential threat. Most are likely heavily biased, however. But moving past people’s opinions, are there problems that these robo-advisors currently face? The “I Love Wall Street” blog recently discussed the problems ahead for these robo financial advisors in one nice table.

Robo Financial Advisors

Table Courtesy: I Love Wall Street

First, the article deconstructs the optimistic view of a 14 million household potential, as the three robo-adviors combined currently only have 0.31% of that. 

“I want to celebrate that 14 million household optimism, I really do. But, as an artist, I’m dark and tortured, so I can’t. When I see that after six years in some cases (Wealthfront and Betterment), the average account size between them is still about $47,000, and they now have almost 44,000 clients collectively I just cringe to think maybe we’re seeing another Adam Sandler film in the making. By the way, FutureAdvisor was founded in 2010, and currently has 800 clients.”

But even if the clients come – are the Robo financial advisors’ model profitable for the firms themselves? It may be great for the tech savvy who found their wives on Tinder, but there’s a question on how much money is needed to support all these (coming soon) clients . The article suggests these robo financial advisors are spending around $14 mm and only taking in $3.8 mm in fees, collectively.

“The real liability in this equation is simply reality; the robots need humans. Today, there are roughly 100 people running the robots. So, if these employees are making only an average of $140k a year (my rough estimate using Wealthfront’s own compensation tool), including the executive suites, and “world-class” engineers and programmers, and all the people who still need to answer the phones and emails, then they are burning through roughly $14 million a year. Any guesses on what that number really is?”

The “I Love Wall Street” post wraps up the counter argument to the robo-advisors being hugely successful with a little thought experiment involving the big wirehouses. The two largest problems facing these robo financial advisorsis lack of profit, and lack of clients, which are departments the big banks are not lacking. What if the big banks like JP Morgan, Bank of America, BMO, and PNC all of a sudden want to adopt this robo-advisor theory. It would be as simple as logging into your bank account, noticing an ad on the side of your online statement offering simple, automated investments, and the tech savvy adopters lives just became that much easier – with their banking and investments now all in one place (the only thing better than not talking to people, is finding what you need in one app instead of two!)  If robo-advising becomes big enough, and these big banks take notice, what’s stopping them from trying it, and leaving the ones with the original idea in the dust? 

What does this mean for Alternatives?

The rise of the Robo financial advisors might mean tough times ahead for the steady flow of new “Liquid Alternatives”, as their algorithms stick to low cost stock index tracking ETFs and ignore alternatives because of the cost and complexity of coding their return characteristics into the algorithm. Or maybe their algos get smarter and realize that stocks have the worst risk/return profile of nearly any asset class and move away from traditional assets into alternatives the same way institutional investors have for the past few decades.

If an investor is solely looking to track along with the “market”, as if there were only one, with stock index ETFs, these robo-advisors make sense. But investors truly looking to construct a portfolio which produces returns based on unique and different return drivers, not just the growth of earnings for US companies, robo-advisors might not be the best decision. Given the successful bull market in the past 5 years, the average millennial investor didn’t need the phone call to talk return drivers; all they really needed was to invest in long Stock ETF’s. But this bull market isn’t going to last forever (even if it seems like it will).

The question that comes to mind now is what will happen when the 44,000 clients choosing low-cost ETFs going to do if/when the market experiences a 5-10 year bear market? What will they do when alternatives start showing their true colors? Will they realize that a long stock heavy ETF portfolio might not be the best investment strategy over multiple market environments?  Millennials experienced the dot-com and housing financial crisis when they wear in grade school, high school, college, and just starting their investing venture. They witnessed their parents 401k plans cut in half in 2008. They are much more cautious about when and how they invest than gen x’ers. But does this mean millennials will actually act, switching to an advisor with real portfolio construction and an eye towards protecting against the downside  The only downside protection in the robo-advisor playbook, it seems, are some bond exposure (nevermind rates are still at all time lows), dollar cost averaging, and automatic rebalancing.  The only way for a human advisor to stand out in the near future may be to adopt alternatives and outperform the robo-advisors during a flat to down period in stocks. 

Summary:

The bottom line is even if these robo financial advisorsaren’t making money at the moment, they are threatening to change the way the financial advisor business model works, whether it be temporarily or permanently. Traditional human advisors will not be able to beat robo-advisors when it comes to tweaking investment allocations and risk tolerances at 3:30 AM Christmas morning, or compete with the lower fees; but advisors can adapt and add more technology to their offerings – creating a sort of hybrid between the ease of accessing research and information via the Robo financial advisors and the intelligence and experience of the human advisor. The plane has a pilot for a reason – in case something goes wrong (although I’m sure we’ll see the day when planes are flown automatically with a single pilot on the ground monitoring multiple flights).

The best strategy for advisors might be to go where robo-advisors can’t. To access privately offered alternatives, to provide planning services in addition to investment portfolio, to meet you in person… (there just might be a few people out there who still enjoy that).

So, what’s your verdict?