What robo advice means to advisors

A taxi license in Toronto sold for $360,000 in 2012.

One year later, reports Peter Cheney of The Globe and Mail, the average price was $153,867.

And, by 2014, the price had fallen to $118,235—that’s a 67% drop in two years. Cheney cited the introduction of ride-sharing service Uber as the primary reason for the decline. Robo-advisors are the investment industry’s Uber.

An advisor at a robo-advisor presentation recently told me, “We feel like taxi drivers and Uber has just come to town.” In Canada, over the past 18 months, five online investment services firms have launched; more are coming. Let’s evaluate that advisor’s concern.

The problem

Money management has become a commodity. Tougher corporate disclosure rules, expanding public access to news and the availability of low-cost investment choices have dulled any edge professionals once enjoyed. Inexpensive web-based asset allocation has accelerated this commoditization. Robos address not only new millennial investors, for whom investing is just another online experience, but also retiring baby boomers, for whom reducing costs is the most obvious way to preserve capital. As a result, many of Canada’s approximately 82,000 MFDA advisors and 28,145 IIROC advisors will have to rethink their value propositions and upgrade their practices to prosper. Disclosure under CRM2 may contribute to more awareness about the cost of advice, but, even if it does not, expect robos to broadly and publicly promote their biggest advantage—low fees.

Chart 1, this page, shows the important factors that are driving early adopters to robo-advice. Low pricing and simplicity are not surprising elements, but given the unsophisticated investment approach offered and the limits of web-based service, investment advisors should be able to compete.

With all-in costs (including product expenses) of 0.50% per annum or less for robos, versus 1.5% to 2% for full-service fee-based advisors, the arithmetic is compelling. After 25 years at a 2% annual fee, about 38% of all accumulated capital goes to fees, compared with only 11% at a 0.5% fee. On $10,000 with a 7% annualized return for clients, this is the difference between paying $20,410 in fees compared with $5,997 (see http://bit.ly/1EjfR3Y under “Great fee debate” for the calculations).

Robos have driven the value of asset allocation to zero. Their ETF-based portfolios, while basic, will be difficult to outperform. Advisors who primarily offer asset management, and who compete based on price and performance alone, will struggle to compete.

Robo advice: what it isn’t

Automated portfolio construction is not rocket science. Robos embrace modern portfolio theory and the buy, hold, rebalance approach. Simple is often good enough, particularly for new investors, for whom asset allocation and diversification are just buzz words. A diversified portfolio alone adds value for investors who currently hold either all cash or high-cost mutual funds. Robo-advisors do not yet sufficiently address specific client needs or adequately control for market volatility. Their rudimentary “buy, hold, rebalance” method is simplistic and outdated, but many advisors use the same approach.

Robo algorithms typically use five to seven questions to establish how much money is being invested, the time horizon, risk tolerance and goals, just as typical KYC questionnaires do. The visitor is slotted into either a model or custom portfolio with an asset allocation that often includes specific ETFs.

In many cases, the portfolios are automatically rebalanced to the starting asset mix, and ancillary services like tax-loss capture for taxable accounts is included. If advisors use the same technology, they can spend less time managing money, where they can’t add much value, and more time gathering assets or developing deeper client relationships.

Advisors offer value by providing financial, tax and estate planning that robos in Canada do not offer in a meaningful way…yet. U.S. robos are gearing up to offer these components, and promise to provide consistent and thorough planning capabilities soon. So, offering these services may not be enough to compete.

The future of advice

Today, consumers expect the products and services they buy to address their personal needs. For instance, Netflix gives subscribers control over time and content. The investment industry has not kept pace. Investments continue to be about products, not the investor.

For the taxi industry to compete with Uber, they could invest in Uber-like software that shows clients where cabs are in their vicinity. The financial advice industry can similarly adopt algorithms to save time and improve efficiency as mentioned above.

Alternatively, advisors can incorporate more sophisticated systems that build personalized portfolios with integrated risk controls and goals-based systems that automatically guide each investor towards specific financial targets (also known as GPS or satellite-navigation systems). This could help to distinguish their practices. The takeaway: provide a more robust approach by guiding investors to their financial goals with the help of technology, and consider risk-management tools that help portfolios to de-risk when market volatility is elevated.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.