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Fear Not The Robo-Advisor
There has been a great deal of hoopla lately in the media about the “Rise of the Robo-Advisor,” i.e., low-cost, online wealth management advice providers. Dozens of start-ups (i.e., Betterment, LearnVest, SigFig, etc.) have emerged, and now three different aggregators have launched their own robo-advisors. A recent poll showed that many industry executives are concerned about the potential “disruption” from these firms, and there has even been some talk that this new business model will ultimately make the traditional wealth manager extinct.
Driving a lot of this frenzy has been a flood of venture capital pouring into such companies, including most recently a $35 million capital raise by Wealthfront. With so much “smart” money pursuing these businesses, how can they not succeed?
All of this sounds eerily similar to a dystopic science fiction – the key word being “fiction” – that was peddled 15 years ago. Does anyone else remember how in the late 1990s technology was going to “change everything” and dot-coms were going to put everyone out of business?
Obviously, that did not quite work out as forecast, as the industry is about five times bigger today than it was then. The current narrative of the robo-advisor replacing the traditional wealth manager is equally ridiculous.
The biggest reason is that the robo-advisors’ current and future clients are very different than those of traditional wealth managers. Moreover, these platforms do not, cannot and will never be able to provide what traditional wealth management clients need, want and are willing to pay for.
More specifically, clients do not go to wealth managers for advice; rather they go to get their problems solved. When clients first show up in a wealth manager’s office, they typically do not even have the first idea of all the things they should be worried about, much less what to do. And although they have a material amount of money to invest, their finances are chaotic – you know, a shoebox full of mutual fund statements and insurance policies – many of them sold to them by a cousin Elmo who everyone in the family knows is clueless. The clients also have aging parents and kids getting ready to go to college, and they are unsure what is going to happen to their business and/or careers, etc., etc. What they are really looking for is someone to help them figure all this out.
A very thoughtful academic, Meir Statman of Santa Clara University, created the most apt description of wealth managers by labelling them “financial physicians.” And just as you don’t go to a doctor only to get medicine – rather, you go first to get a correct diagnosis and then get the right treatment – the core value-added of wealth managers is helping clients to first diagnose and then craft solutions to their problems.
Helping clients do this typically involves a grueling 18-month process that takes a great deal of the wealth manager’s time and expertise (and judgment) and is often very emotionally exhausting for clients. It forces them to make many personal decisions that they would otherwise prefer to simply defer. The good news for the advisor is that after having completed this process, most clients would rather have their teeth drilled without Novocain than have to go back and do it again.
Now back to the mighty robo-advisors. What they mostly offer is low-cost asset allocation advice. Sure, some of the sites have online questionnaires designed to help clients figure out which model investment portfolio makes the most sense for them. But this is night and day different from the sophisticated, customized holistic financial advice provided by traditional wealth managers and is not what most clients need or want.
Another way to think of it is to come back to the physician analogy. What robo-advisors enable clients to do is perform a very limited self-diagnosis. However, this is like asking someone to perform surgery on oneself, something that generally does not end well. The sites make their money by selling the medicine that clients pick out for themselves.
To be sure, there is a screaming need for something like robo-advisors given that 65% of all adults in the United States have a net worth that is less than $100,000 – and thus lack the resources to afford comprehensive wealth management advice – and their only current alternative for financial advice is the local stock broker. And, certainly, a couple of robo-advisors will ultimately become very successful businesses.
However, many (if not most) will not and those that do are going to burn through immense amounts of capital. Why? These businesses have not yet figured out how to attract sufficient numbers of clients quickly enough to make money.
Consider Wealthfront – easily the most successful robo-advisor to date – as an example, and let’s do the math:
It has been around for eight years, has already burned through about $30 million of capital (in addition to the $35 million it just raised) and its SEC disclosures say it has about $800 million under management from 8,800 clients. It charges 25 basis points, but it waives the fee on the first $15,000. I would figure the company has revenue of, say, $1.7 million to $1.8 million. That’s not much, and it’s before paying any operating expenses.
Let’s optimistically assume it takes only $10 million per year to just run the company (i.e., before any additional CAPEX, something that it will require lots more of in the future to keep its technology current). This means to generate a 20% cash-on-cash annual return on invested capital, it will need to add 16 times as many clients as it has now and it will need to add them very soon.
The firm is backed by some of our country’s most successful venture capitalists, who, I have little doubt, think that quickly adding 130,000 site users is no big deal, especially given how millions of people flock to new technology sites every year. But this ignores how different robo-advisors are from companies like Facebook or Twitter.
With the latter, people can at no cost post pictures of their cats or most recent tattoos and ask others to tell them how much they like it. In contrast, robo-advisors must convince clients to pay fees – an anathema to most Internet users for any site. More importantly, they must also convince users to entrust the site with a material portion of their net worth.
A key reason (or so it appears) that venture capitalists are ignoring this thorny issue of client acquisition is that they expect their robo-advisor to be the next Financial Engines. Started in the mid-1990s by Nobel laureate Bill Sharpe, that company today is publicly traded and has a market cap of about $2 billion.
But it follows a very different business model (in terms of client acquisition) than robo-advisors. Most of its clients are companies that have 401(k) plans – it has $830 billion of assets “under contract,” for which it is paid 2 to 3 basis points. It also trades at 67 times earnings, which suggests that the market thinks it is going to grow at a very high rate for a long time (no small feat when one already has $830 billion of assets) or that its market cap will quickly shrink.
Ironically, Financial Engines initially tried following the same business model being adopted by robo-advisors – i.e., B to C. However, it quickly learned that it could not quickly attract sufficient numbers of clients to remain viable. So it reinvented itself as a B-to-B business that provides a technology tool for 401(k) plan sponsors to use with participants.
Given all of this, my advice to wealth managers is: Do not fear the robo-advisor; rather, study them. Although they are not really competitors, and many are not here for the long term, they are developing technology tools that over time you may want to adopt to make your business more efficient.
Mark Hurley co-founded Fiduciary Network in 2006 and serves as its CEO.
Find the published article online here.