Do you already take advantage of your robo-advisor? Is this a new AI (artificial intelligence) monster or a declaration of bankruptcy to my financial advisor?
We are living in new times and new technologies drive new business models. Robo-advisors are one of these financial advisor services, which automatically manage your financial portfolio. Robo-advisors emerged around 10 years ago and today there are over 100 different robo-advisory services.
What is a robo-advisor?
A robo-advisor is per definition an online application that provides automated financial guidance and services. The digital financial advice is based on mathematical rules and algorithms executed by a software and therefore does not require a human advisor. The software utilizes its algorithms to automatically allocate, manage and optimize clients’ assets.
How does it work?
The easiest approach using a robo-advisor is quite simple. First step is the investors profile, second step is the automated advice. The client fills online a short questionnaire and determines the risk of his investment and expected return. The one example I know are 8 questions which are based on behavioral economics and brain research.
The entry stage is to reflect listed ETF’s (Exchange Traded Funds). Hence the investment will follow the stock or bond indices. The underlying investment consists of bonds and equities in a rule based asset management, you can also call it a passive investment in indexed funds.
Most robo-advisors act as intermediaries between their clients and their portfolio, which you already have with your bank. They do not have a bank license, which has high restrictions to obtain.
If the investors prefer more sophisticated advice, they can go for more dedicated fund management or more complex automatisms such as algorithm based adjustments, re-balancing proposals or predefined rule sets for investments. Also the underlying investments of bonds and equities will be enhanced with currencies, commodities and other assets.
Today, most clients follow automated investment advice with integrated account management and either active or passive portfolio management.
The more artificial intelligence is built in, the more self-learning algorithms will start shifting assets automatically and fully automated investments will take place. Sounds scary? Not really. Clients can choose between active and passive management styles. You can choose also both.
The passive management style keeps his predefined parameters and restores the asset mix on a frequent basis. It aims a long term growth by basically following the markets. Refer to the example further below in this article.
The active management style is livelier by a constant data collection and analysis of the market as feeders to the algorithms, which propose shifts in the asset allocation. It aims to outperform the market by basically focusing on a higher beta factor.
The question is how well are the machine learning techniques continuously improving their algorithms in order to improve the performance?
When intelligent machines do all of your work, what will we do all day?
Have you thought about what you actually want?
Why should we use a robo-advisor?
The main argument in favor of a robo-advisor is the cost / performance ratio. Because of a moderate to minimal human intervention, they have a much smaller service fee structure than traditional human advice. If you follow a very simple approach on ETF’s only, your management fee will be much lower. The more complexity you add, even if it is automated, the higher the fees will be. A higher degree of diversification will promise a higher chance of outperforming the market. However, it is certainly more cost intensive to manage multiple investment vehicles compared to reflecting an ETF only.
In most cases, a human client advisor follows the recommendation of his bank, based on external or in-house research. This is human and cost intensive and often the performance is not better than comparable indices.
People who are in favor of robo-advisors will tell you to digitize yourself before you get “kodaked”. The famous Kodak Company did not adapt fast enough to the merge of digital photography in the nineties and went bankrupt a couple of years ago. Same arguments are used with the hotel industry and Airbnb or Uber with the taxis. Personally, I don’t believe companies like Marriott will go bankrupt because of Airbnb, however, in certain segments, they will get hurt.
The travel industry déjà-vu in wealth management
The financial industry goes through a period of disruption, where you can see the impact in new business models, new processes, and new ways of engaging with clients. The critical foundation of data currently succeeds the digital transformation. It is similar to the travel industry which went through a large paradigm shift starting around 30 years ago. The travel and tourism business shifted from old mass holiday packages to new customized ways of travel. Consumers became the new drivers using the power of the internet to compare products and services at their fingertips.
Today, the new competitors of the wealth managers are the Googles and Amazons, who know more about their clients than the bankers.
The new art of wealth management is to take a part of the value chain and digitalize it. The Finance industry, however, is not yet standardized like the Ubers and Airbnb’s. It is still a kind of national business, even though we have EU law directives such as MiFID (Markets in Financial Instruments Directive) in place.
If the robo-advisor is not performing, you can blame the market taking the scenario that the robo-advisor has a simple investment approach such as reflecting an index with ETF’s. In case the investment approach is more complex, you can blame the algorithms. Do you still believe you can blame your wealth manager? Do you have a trust based relationship with a tolerance for mistakes, because you prefer to deal with a human being instead of a machine? If a mistake happens, the bank would never admit to it unless you go to court to prove it. The complexity is increasing due to growing regulations and compliance requirements. Automatization is transparency and you can reduce legal and compliance issues.
The way a robo-advisor should be seen from a banks perspective is like an Uber for wealth management. There should be no custody, no trading and no legacy. The value chain falls apart. If you are a Swiss based robo-advisor, your digital radius is not limited but due to the national varieties ideally in Switzerland. The infrastructure and facility managers of a bank will think twice whether they want to invest 2-3 Mio. in building a new physical subsidiary, which has a physical radius of 1 km instead of investing the same amount in their robo-advisory products which has a much larger digital radius. Ok, you can argue that we are not comparing apples with apples, however, we need to understand that businesses will take more and more advantage of virtual value chains and move towards digital business models. This also goes hand in hand with an increased acceptance of e-banking if there is a value add such as simple, fast and practical management of financial transactions, whether you are on the move or at home.
Most robo-advisor companies offer their services on a SaaS (Software as a Service) platform and follow the approach robot, scale and automate. They don’t “make” a good asset management. Their mind set is let others (robo-advisors) do it. It is like Uber, who do not own the fleet of taxis, but are taking the advantage of data generation with radical changes.
Is data the new differentiator?
If a robo-advisor can take advantage of the disruptive power of data, do you believe it may be able to replace your financial advisor? One reason is the explosion of data volume. Are we able to manage this rapid growth in order to keep with the data volume? Employees and investors are also moving from data producers to consumers of reports and data users.
Another complexity is where the data is coming from such as mobile devices, social media and the internet of things through online streaming. All these devices slowly adapt to artificial intelligence and machine learning. No one will know where the data came from, once moved to the cloud. If you offer a robo-advisor from Switzerland and operate in the cloud, you need a sole Swiss FINMA (Swiss Financial Market Supervisory Authority) approved cloud to differentiate from your other robo-advisor competitors.
Most financial institutions are struggling with replacing their legacy systems in order to keep pace with the disruptive changes. Mainframes cannot be easily replaced when the code has been developed and maintained in-house for many years or captured in specific applications which are not supported anymore. This is why you will find so many data warehouse projects, where you need to extract data from many different feeder systems, transform it to a useful meaning and usage. Then you need to load it to an environment where you can easily produce reports and relevant information from. A robo-advisor, acting as an intermediary, does not have these typical legacy or infrastructure problems.
Robo-advisors are useless if you didn’t do your homework such as proper data integration, data quality, managing master data, managing data security, managing the large volume of big data and manage it all in a secured cloud.
The human factor can be a risk because we are emotional beings. Every wrong decision is the basis for many more and in most cases wrong decisions to follow. Bad luck attracts misfortune and success attracts success.
Example
A good example to see how robo-advisors come into effect is a joint approach. In this case we look at mainly four different vendors with their expertise in a certain part of the value chain.
The Swiss based insurer Elvia, a subsidiary of the Allianz Group, offers a pure digital investment product for private investors. Clients set their investment goals and determine their personal risk profile.
The robo-advisor technology is based on a SaaS offer, which comes from a Zurich based company called additiv. The product is named additiv DFS (Digital Finance Suite).
Another part of the value chain has been developed by a Swedish credit management and cash collection company called Intrum Justitia and consists of a video identification solution and the ability to qualify electronic signatures to fulfill the client onboarding process.
Anyone wishing to register with this new robo-advisor product can do so via their desktop or smartphone. For the end customer, the process takes a few minutes. During the video chat, a picture of the ID card is taken, the person is identified via software and the contract is also signed.
Last but not least, the custodian bank is Saxo Bank Switzerland.
The insurer can offer a completely digital investment product, which is also distributed online. The target group are long-term orientated private investors. The customers determine their starting amount, their investment objective and their personal risk profile online. Based on the customer’s investment strategy, the insurer invests in appropriate Exchange Traded Funds (ETF’s), managed by the custodian bank.
To sum up, the insurer did not develop the whole product in-house but took rather a best in breed approach to pass the digitization benefits to their customers. They choose the experts in Fintech for the robo-advisor, video recognition and e-signing solution for the KYC (know your customer) and onboarding process and a custodian bank, which provides the ETF’s or any other investment product chosen.
Conclusion
The polarity is not only in society but also in the wealth management industry. The good old days of red carpet retail banking are gone. A private client with less than 1 Mio. in assets will receive the standardized mass products from his bank and could instead easily invest a large portion into an automated vehicle like a robo-advisor. Of course, the bank will give you the impression that with a fortune of 100’000 you will receive private banking attention, however, the products and advise you have access to are standardized.
Only clients with a large amount of assets will receive access to real professional high profile private bankers with sophisticated and individualized research. I have worked along a couple of projects, which were dedicated to ultra-high-net-worth individuals (UHNWI) and got prioritized in the program.
The increasing number of robo-advisors will more and more penetrate the financial consulting industry. Not only because of the speed, but mainly because of disrupting traditional business models.
Recommendation
New is not what is new, but what is perceived as new. If a tool can plan, analyze and forecast in real time across the financial markets with sophisticated algorithms, why should you pay higher fees just because human monitoring and intervention does not add any additional value?
The great thing about private banking and a personal advisor is that we as humans seek social contacts. If a client advisor can read you and between the lines of what you are saying, you may find solutions which a robo-advisor cannot come up with. If investment advisors will not increase on the holistic quality of reading people’s requirements and find investment solutions outside of the box, they will eventually be replaced by robo-advisors. It will be difficult to justify your fees if you cannot beat the machine.
A good personal client advisor requires good judgement and experience. They can take the client’s perspective without pushing their products and really take care of security, perceivability and usability of understanding when robo-advisory makes more sense instead of personal advice.
Personal client advisors will face more and more cost pressures and in the meantime an uncontrolled growth of new regulatory requirements. It will become more difficult to defend the old way of serving clients. You need to stay innovative in order to survive.
If smart bankers and IT cracks come together and think about how we can increase efficiency in managing assets, robo-advisors will certainly impact more the finance industry in the future.
What is your personal experience? Do you use robo-advisors? Feel free to leave your comments.