The Great Good Work Of Robo Advisors

Dave Nadig’s recent blog on the so-called robo-advisor space misses the point about the good these firms are bringing to the investors.

Robo advisors—automated investment services, if you prefer the official term—are the hot thing right now. These are firms that (broadly speaking) create well-diversified portfolios tailored to specific risk targets and manage them for people automatically, through a primarily online relationship.

Wealthfront, the leader in the space, just closed a $64 million round of financing and now has $100 million in the bank. Personal Capital just landed its own $50 million round. Even Charles Schwab is getting into the game.

The gaudy fundraising numbers and general Silicon-Valley-hype surrounding these firms has (as you would expect) created a backlash, with people questioning valuations, debating the sustainability of business models, and wondering if the entrance of 800-pound gorillas like Charles Schwab portends doom for the startups.

Our own Dave Nadig took a shot at the robo advisors recently, arguing they will oversimplify finance and lead people into trouble. I’ll quote here at length from his blog:

“[W]hat’s not to love [about robo advisors]? It’s actually too simple. When things get too simple, people stop paying attention …

My concern is that we’re heading for a world where every place investors interact, there’s a set of ‘robo portfolios’ sitting in front of them, and investors will be lulled into a sense of ‘Well, I’m average; I’ll take the average portfolio,’ and they’ll never think about it again.

They won’t remember to adjust their position as they get closer to retirement. They won’t realize the implications of an early withdrawal. They won’t understand that investing in the stock market while you’ve got credit-card debt piling up is a dumb idea.

Worse still, they won’t think they need a financial advisor, because it’s all being taken care of by computers.”

I love Dave like a brother, but I think he’s massively wrong about this one. Mostly, Wall Street uses complexity as an excuse for high fees, and I think that’s been the case in the asset allocation space for some time. Robo advisors are changing this, for the great good of a great many.

Charging So Much To Do So Little

There are few industries in the world that charge people so much to do so little as investment management.

Actively managed mutual funds charge 1 percent a year or more to underperform the market. Financial advisors tack on a 1 percent (or more) fee to create balanced portfolios of these underperforming mutual funds. Distributors (including Charles Schwab) charge distribution fees of up to 0.35 percent a year to make those mutual funds available. Add it all up and investors may pay 3 percent or more per year just to trail the market, and they do it year after year after year.

It’s absurd.

The good news is there has been a series of breakthroughs over the past 40 years that have fought against these trends.

First, Charles Schwab and other discount brokers broke the back of high trading fees, bringing commissions down from a couple hundred dollars a trade to peanuts (I think I pay $7.95 these days).

Next, Vanguard and other index fund providers broke the back of active management by offering a low-cost, high-quality alternative.

Then, exchange-traded funds broke the back of distribution fees by providing equal access to low-cost products for anyone with a trading window.

The Bind That Ties

What unites them all?

New technologies enabled firms to slash costs by 70-90 percent compared with the status quo, while delivering a superior product. Any time you can do that, you win.

That’s the same thing that’s happening here.

We have all gotten used to low-cost (but high-quality) trading and low-cost (but high-quality) products, but most investors have been either locked out of asset allocation advice or stuck paying big fees for routine strategies.

Not anymore.

Now I can have Burton Malkiel at Wealthfront manage a risk-adjusted, well-diversified portfolio that follows a glide path, rebalances and tax-loss-harvests for me using low-cost ETFs for 0.25 percent a year.

And if I don’t like that flavor, there are a dozen other providers with their own variations, all charging me peanuts for portfolios that—while we could argue on the edges—are probably better constructed than the portfolios held by 90 percent of investors around the world.

What People Are Missing

People who don’t like the robo advisors miss a few things.

The first is that they target a massively underserved population. Financial advisors do great things for people, but for the most part, they don’t want to talk to you unless you’re investing $500,000 or $1 million or more.

There are a few who will—Ric Edelman comes to mind—and they get excoriated in the press for charging high fees. I’ve never understood this. If you’re going to take on people with $10,000 in their accounts, charging 2 percent a year only nets you $200/year. That’s hardly overcharging; in fact, I think it’s a valuable service.

Robo advisors are the other side of that equation, putting high-quality asset management services within reach of most of the working population, at extraordinarily low fees. That’s a real service too.

[Note: Ric Edelman and Wealthfront CEO Adam Nash will debate “The Future of Financial Advice” at the upcoming Inside ETFs conference. Check out the agenda here.]

But the second thing people miss is that they don’t project out with enough imagination.

These firms have already created great investment portfolios and offer services like tax-loss harvesting, single-stock diversification programs and so on. With $100 million in the bank, don’t you think Wealthfront can bite off more of the planning and personalization that comes with traditional advisor services?

Meanwhile, Personal Capital’s hybrid model already focuses on an integrated view of your finances, and they’ve got $50 million to spend to improve that service and get it out to the world.

Before you sell them short, think about how far these firms have come in the past 18 months … and then imagine where they’ll be in five or 10 years.

Room For Advisors—Human And Robo

Will automated investment services replace human advisors? Of course not. There will be, as there always is, a continuum, from do-it-yourselfers to the high-touch ultra-wealthy.

But I do think they’ll be a phase shift downward in what people pay for basic asset allocation advice across this continuum, as new technologies automate and simplify some of the tasks that used to seem so complex to the average investor.

That’s as it should be. And it’s a very good thing.

Contact Matt Hougan at [email protected].