Note: this article was written in collaboration with Arnaud Amsellem, aka the R Trader.
Over the last few years the term robo-advisor has become a buzz word for anyone paying little attention to the evolution of the financial industry. As a matter of fact, a lot of new players have emerged proposing a so called robo-advisor service.
The chart below shows the estimated US AUM allocated to those players for the next years up to 2020.
In this article we aim at going beyond the simple description of the robo-advisors industry. We try to identify and classify the players, understand how they operate and challenge a few widely accepted facts. We then analyze the impact of robo-advisors on the asset management industry and what value they bring to standard investors.
THE ROBO-ADVISORS LANDSCAPE
There is no widely accepted definition of robo-advisor and the mainstream definition is as following: “Robo-advisors are a new class of players that provide portfolio management online with minimal human intervention”. This definition is valid but not accurate enough.
- Allocation rather than advice: Most if not all robo-advisors offer automated asset allocation service. In other words robo-advisors should really be called robo-allocators allowing the client to diversify his portfolio across a range of financial instruments. Some players manage both strategic and tactical allocation (overall allocation and picking of underlying)
- Low cost: A quick glance at any robo-advisor pitch reveals that this is one of their major selling points. They usually charge a fraction of what a traditional advisor/asset manager would charge.
- Convenience: Being exclusively on-line service, robo-advisors allow greater flexibility. The investor can increase/decrease its allocation or subscribe/unsubscribe to a service with minimal additional cost and reduced administrative hassle.
Even if all robo-advisors share the characteristics described above they form a very heterogeneous group of financial services providers. 3 types of robo-advisors can be identified each targeting different type of investors with different degrees of financial knowledge, financial situation and investment objectives.
- Pure advisor: This class of robo-advisor provides allocation only services without providing the accurate list of instruments to support the investment advice.
- Standard Asset Allocator: On the top of the above service, Standard Asset Allocators provide an accurate list of instruments to invest in and manage client’s portfolio. These players actually compete with traditional asset managers.
- Algorithmic Portfolio Manager: This type of service targets financially literate investors wishing to synchronize their brokerage account to an automated advanced trading strategy.
Overview of Industry Players
ROBO-ADVISORS: MYTH VS. REALITY
Behind marketing selling arguments some point have to be clarified.
Overview of Robo-advisors committment
1. Access to cutting edge strategies to anyone: Looking at some robo-advisor investment strategy is very informative. Wealthfront for example gives a detailed explanation of its investment philosophy and process on its website. In a nutshell they rely on a standard Mean Variance Optimization (MVO) approach to build an optimal portfolio. This methodology was initially developed by Harry Markowitz in 1952 and has been extensively used by all quantitative asset managers for nearly three decades. So, the argument saying that robo-advisors give access to anyone to cutting edge investment solutions appears largely over stated even if they make the whole process more transparent and appealing even for investors with limited financial knowledge.
2. Use of low cost investment vehicles: Most robo-advisors partially explain their low fees by the use of low cost investments vehicles (ETFs). This is an interesting approach but traditional asset managers may offer exactly the same service JP Morgan Asset Management for example went even a step further by using some of its competitors ETFs (State Street US Sectors ETFs) to create its own product: a US sector rotation strategy wrapped up within a new ETF (JP Morgan US Sector Rotator Index). Another interesting example is the Goldman Sachs VIP ETF. This ETF tracks the 50 companies that matter most to fundamentally driven hedge funds as found in their 13F filings (1). So once again in term of investment vehicles robo-advisors might not be that different from traditional asset managers.
3. Lower fees: Are robo-advisor really much cheaper than traditional Asset Managers or Private Bankers offering portfolio management? This is true in some cases but not always. The offer is very diverse and comparison among players is made difficult by the different fee schemes they use. However some features are obvious. Some robo-advisors charge a single flat fee covering all costs. In this case, robo-advisors are most of the time really much cheaper than standard advisors. However some robo-advisors charge a flat fee plus some other fees and even brokerage fees in some cases. Compared to classic portfolio management services provided by Private Banks, brokerage fees should be lower. Nevertheless, for an investor with an active strategy (high turnover) it becomes very quickly too expensive. Between those two extremes there are all possible combinations and as a rule of thumb investors should watch fees closely and make choice based on their individual needs.
4. Transparency: Are robo-advisors more transparent? Generally speaking yes. The fees are made more transparent and the investment process (in most cases) is more accessible to the investor. As a result, investment does not sound like a black box to the layman person even with limited financial knowledge.
5. Performance: Traditional asset managers are required to provide GIPS performance but there is no live historical performance available for most robo-advisors (One exception is Yomoni in France, such transparency should be welcomed). This is rather surprising as good performance has always been a key selling point in the industry. In a recent article, Meb Faber reconstructed robo-advisors historical performance (2). Obviously this is based on strong assumptions but it gives a good indication of what to expect. We extended Meb Faber’s analysis to recent years (Jan. 2014 to Feb. 2016) by applying the allocation described by Betterment (B60) and Wealthfront (W60). We estimated the performance and compared it to an equivalent benchmark based on international indices: 60% Bonds 40% Equity (Bench.) (3). In the table below results speak for themselves: both Betterment and Wealthfront fall largely short of the standard allocation model with barely positive Sharpe ratios.
Overview of Betterment B60 and Wealthfront W60 performance from Jan. 2014 to Feb. 2016
That might explain why performance is not marketed by robo-advisors. Of course, two years is a short time period for a long term investor but as robo-advisors intend to compete with traditional asset managers they should clearly display performance to clients.
STRONG IMPACTS AHEAD
In any industry the emergence of new players disrupts the established order and the financial industry is not an exception.
- On the investor side: Overall, robo-advisors are good news for investors. They provide on average a cheaper alternative to traditional advisors/asset managers and given the richness of the offer they can meet almost all investment needs from a simple and fixed allocation to algorithmic portfolio management. However investor must be very selective and choose a robo-advisor that really suits their needs. In particular fees must be scrutinized to ensure they are compatible with investments objectives. So far robo-advisors have been targeting mainly the retail market and we anticipate this to slowly evolve toward institutional clients for two reasons. First there is a clear trend toward lower fees in the industry and robots have lower costs compared to industry standards. To compete on prices, standard asset managers will have to reinvent themselves. Second robo-advisors are fundamentally a wrapper that encapsulate any kind of strategy within a simple envelop making the sale process easier.
- On the asset managers/advisors side: The emergence of new players providing comparable services for a fraction of the price will undoubtedly shake current practices. An obvious immediate effect is margin going down significantly. The process has already started with the rise of ETFs over the last few years but we anticipate the phenomenon to gain momentum with the arrival of robo-advisors. If they want to survive, asset managers will have to reinvent themselves by offering solutions that are both cheaper and more efficient for investors.
We think the decrease in revenues is inevitable and in their current organization, asset managers cannot compete on fees with efficient robo-advisors. However they have the resources and the knowledge to propose innovative solutions. One area to explore is the wrap-up of products within a cost efficient envelop (see the JP Morgan example above). We see this as a big trend and potentially massive market shares could be captured by players capable of providing cost efficient advanced strategies to the mass market.
So far robo-advisors managed to take-off mainly by competing on fees with traditional asset managers and offering an easier to use service. This is good news for investors but in the coming years if they do not manage to offer competitive and consistent performance, no matter how cheap they are they will not attract new customers. Ultimately robo-advisors will be under the same pressure as traditional asset managers the only difference being a lighter cost structure at least for now.
1 Source Bloomberg: A 13F is a quarterly holdings report required for any hedge fund company with over $100 million invested in U.S. equities
2 http://mebfaber.com/2014/05/30/the-wealthfront-and-betterment-allocations/ and http://mebfaber.com/2016/01/01/2015-performance-review-betterment-vs-wealthfront/
3 Bonds: iShares Core U.S. Aggregate Bond ETF (AGG), Equity: Vanguard Total Stock Market ETF (VTI)