Where robo-advisors are better
than financial advisors
In this section and the next two, we compare robo-advisors and traditional registered investment advisors.
This section focuses on the advantages that robo-advisors have over traditional financial advisors.
What robo-advisors can do that financial advisors can’t do
Robo-advisors are computer software. Computing power is cheap and plentiful. Hence, robo-advisors can do massive repetitive tasks and for a very low cost. Financial advisors have a much more limited bandwidth for some.
Robo-advisors are computing a tailor-made asset allocation for each investor. That is a feat in itself. Most financial advisors have a few buckets defined for groups of investors with similar risk appetite instead. The asset allocation is de facto replicated to all investors in the same class. Actually, robo-advisors, if they ask similar questions than financial advisor do, they will interpret them with more granularity. The question “Which age are you?” is indeed more accurate than the question “In which age band are you?”. They can refine the client description indefinitely. Practically speaking, a financial advisor with 100 clients will not divide his universe in 100 buckets. He will divide his pool into 5, 10, maybe 20 groups. Betterment, which has 400,000 clients, has 400,000 buckets of clients. Every investor is considered individually.
When a robo-advisor calculates an optimal asset allocation for a given client, he uses the client’s specific characteristics, the market environment and a largen number of computing and optimization parameters. The program does these operations in a fraction of a second, and repeats it regularly, daily at a minimum. A financial advisor also makes this same calculation, but he uses less parameters and will not be able to repeat it that frequently. Between the yearly market trend assessment of his company’s investment committee and his own (monthly?) revision of positions, a financial advisor probably re-assesses his buckets on a quarterly basis. Many market events will require his attention, clients will call him all day if he doesn’t call them first, support functions will ask him for instructions / confirmations and answers on settlement and legal issues… The financial advisor has so many fires to cover at any moment, it is unlikely that he will find much time to reassess optimal allocations for each of his buckets more frequently than quarterly. Robo-advisors’ instantaneous asset allocation computations will beat a human at every race.
To improve an initial asset allocation, you need either better information or a better interpretation capacity. Robo-advisors do a very decent job at asking the investor’s background and goal. They compare or match what a financial advisor does, at least for the many who constitutes the lion’s share of the pool of new (less affluent) investors brought forward. Computers are often better at interpreting large amount of data and have definitely beaten human at brute-force simulations and high-dimensionality problems like portfolio optimizations. The latest techniques (machine learning, neural networks, AI…) may not be quite efficient at forecasting the future prices, but they have certainly demonstrated their capacity at dissecting and recognizing investors. Robo-advisors can provide an excellent asset allocation to 90% of their clients and can detect which clients have a lower quality confidence.
Once an asset allocation is defined, the portfolios of each (bucket of) client(s) needs to be re-allocated. This means deciding which instrument to buy and to sell, executing them through a phone or a computer, re-allocating them to the clients, ensure cash and settlement operations, monitor risks and positions, record changes and inform clients. For each client. While systems have simplified many of these tasks, they are still way more manual for a human at a traditional RIAs than what a robo advisors does. The robo-advisor will handle all decisions, executions, recording, risk management, cash allocation and reporting entirely on its own. Robo-advisors’ execution and back-office settlement capabilities will beat a human at every race.
Robo-advisors can also execute other business functions that financial advisors know how to do but do not have the time to do. They can for instance sweep customers’ account for unnecessary cash and automatically invest it into money-market funds. They can transfer assets between vehicles and accept automated deposits. They can inform the client about his portfolio or the market conditions. They will generate month-end, quarter-end and year-end report. An AI will answer online questions that investors will submit and save precious phone time for the financial advisor.
On a different topic, robo-advisor companies, by the nature of being online only, have invested a lot of resources in online messaging. They have content to educate investors about securities, vehicles and processes. They will explain why saving early in one’s life is important. They will remind and inform clients. They can answer questions intelligently. A financial advisor will never find the time for such functions for his clients, and even less for prospective clients or the public at large. Robo-advisors’ educational capacity will beat a human at every race.
Robo-advisors answers the need and the culture of the younger generations. Millennials are used to computers, apps and the AI interfaces. They are not offended by the absence of someone to email or talk to if the support can get them the answer they need. They actually prefer to pay less for such a simpler service anyway. The baby-boomer generation on the other hand is accustomed to the phone call. They may accommodate an email, but trusting an app on a cell phone does not belong to their way of life.
The real weaknesses of financial advisors
The main qualities of robo-advisors are also the financial advisors’ main weaknesses.
Financial advisors simply cannot compete with fees around 0.25% or lower, a fortiori zero. Their fixed costs, the salaries and variable compensations of their staff combined with the maximum number of clients they can manage requires a much higher level of fees. Even if fees could compress a bit. The typical range of 1-2% remains several times the fees requested by robo-advisors.
Do not forget that fees compound over time, and that the compounding effect increases with the rate. A 1% rate added to a performance compounds to 22% over 20 years. A 2% fee compounds to more than 50% over 20 years. Is your financial advisor bringing you enough value to double your assets over the next twenty years? It is a hard question to answer.
Financial advisors simply cannot compete with low AUMs, for the same reason that financial advisors cannot compete with low fees. A wealth manager can rarely handle more than 100 clients. Let’s take an example. If his average client has $40,000 and pays 1% a year on his AUM, the advisor’s revenues are $40,000 x 100 x 1% = $40,000 per year. You can’t even pay an office rent with that amount.
Robo-advisors are unbiased. They will not recommend an investment over another, based on how much money they will receive. You pay the management fees of these investments in your brokerage account; they simply place the order. It is not the case for financial advisors. RIAs are paid an introductory fee and a percentage of all management fees for introducing a client to a fund. There is a reason nobody dared to ask too many questions about Madoff. He was paying a hefty 1% a year to the financial advisors who were recommending his funds. 1% a year on a $billion is good money.
Recommending an investment because the advisor collects a higher margin is both unethical, illegal and at the investor’s expense. Even if existing and coming regulations prevent this, it’s the investors who eventually pays the price for a high introductory fee. This materializes either in the form of higher management fees (to pay for the kick-back) or of a lower market performance (lower quality investment).
Financial advisors and investors may not have the same amount of grey matter as robo-advisors have. Said crudely, Wall Street is said to attract the best and the brightest. There are not enough geniuses to fill all the RIA shops in the country. Once the most sought-after analysts have filled the roles at the top broker-dealers, at the prestigious hedge funds and at the newest fintechs, the reminder may go to the top financial advisors. But they are unlikely to join mom and pop’s financial advisory office in Middletown America.
What financial advisors could do better
If the younger generation is looking for an online interface rather than a human on a phone, if the public at large wants and needs information to learn, if costs are reduced and performance is improved when RIAs automate regular tasks like clearing, trading, rebalancing, reporting, monitoring and sweeping, then the onus is on the financial advisors to invest into technology. Their revenues and margin will improve if they increase efficiency and productivity. While there may not be enough resources for all RIAs, not enough market for all RIAs, those who don’t invest and improve will not get a piece of that new cake. Their margins will continue to erode as well.
Robo-advisors have invested large resources into dash boards, efficient interfaces, colorful environment, valuable content. At this stage, they get the media buzz and benefit of the innovation they have brought. It’s only fair.