How Robo Advisors Are Impacting Investing

April 28, 2014

Corporate Insight’s Grant Easterbrook breaks down the segment, and sheds light on what’s in it for investors.

The growing segment of so-called robo-advisors is far more vast and diverse than the moniker suggests. They are not a one-size-fits-all solution that applies to all investors.

Grant Easterbrook, senior researcher for Corporate Insight—a consulting and intelligence firm—spent a few years researching and connecting with 120-plus of these relatively off-the-map online advisory firms. He published an extensive report that breaks down this multibillion-dollar burgeoning industry into 10 different categories, each offering investors an entirely different set of services. Think things from algorithm-based investing to online managed accounts to trade mimicking platforms.

That diversity offers plenty of opportunities for investors looking for all kinds of help with their portfolios, but it also poses a daunting task of understanding what’s out there and knowing how it can best serve you.

We caught up with Easterbrook to discuss some of the major trends shaping this startup industry, as well as to understand the benefits and pitfalls of bypassing a traditional advisor or money manager. In the end, what’s abundantly clear is that online advisories are here to disrupt the norm in the traditional wealth management space, and reshape the way we invest.

ETF.com: We're seeing a massive proliferation of these online-based financial advisors and investment tools. What’s driving the growth of this segment?

Easterbrook: A lot of these firms can be grouped into a post-financial crisis generation of startups. In the aftermath of the crisis, a lot of venture capitalists and entrepreneurial minds got their eyes set on the investment industry, on personal finance.

They saw the major players were battening down the hatches, trying to survive in an industry that was perceived to have a lot of flaws. They saw an opportunity to offer an online-only service that’s lower cost. The idea was that people were so burned out by their advisors or their institutions they just might consider trusting a new online service.

ETF.com: You looked into more than 100 of these firms, and you broke it down into 10 different categories of various services and tools they provide. Still, it struck me that, in general, most of them point investors toward passive index investing. What do you make of that?

Easterbrook: For the most part, they're trying to be competitive on low cost. To do that, they emphasize passive investing.

And if they're not using any human touch, it's almost easier, too, to put forward passive management rather than try to explain and justify why they think this or that active fund is better than the passive option. There are a few exceptions in there, but for the most part, these firms are certainly favoring passive options.

ETF.com: ETFs, then, play a central role in the growth of this online advisory industry?

Easterbrook: Certainly. One thing that's changed in this generation of startups is that ETFs have come front and center, with more and more investors using them. They’re more comfortable with them now than they were, say, in 2006.

A lot of these firms are using low-cost index ETFs to minimize costs, because that's one thing you can control; performance is out of your control, but you can minimize costs with ETFs.

 

ETF.com: As you look at these firms, however diverse, are there any benefits they all share? What makes them a good option for investors?

Easterbrook: To speak broadly, relative to their established competitors, they generally have relatively lower costs, relatively lower minimums, better transparency—or at least online transparency—good pricing for fees and performance.

It's very easy to figure out just how much you're paying. And for the most part, you can track performance online, compared to an index.

They have modern and user-friendly websites, which many of the traditional wealth management firms lack. And for the most part, they don't have as many potential conflicts of interest.

ETF.com: On the flip side, what are the pitfalls in this industry?

Easterbrook: For the algorithm-based advice group and the low-cost managed accounts [like Wealthfront and Betterment], for those firms, there's some concern over what's going to happen during a market crash.

Let's say the doomsayers are right and there's a major market downturn. For those firms that don't have any kind of human touch or account manager, how are they going to perform?

In the last crash, we saw a lot of people flock to the sidelines and average Joes tend to get caught in the sell-low-buy-high trap. That's a problem with human emotions, and that's something that's hard to address when you don't have a human relationship, and you're just doing email updates, blog posts. That will be a challenge for these two types of firms. I'm not saying they won't do fine, but we don’t know.

Another pitfall is that in many of these firms, you're replacing the human element and relying on a questionnaire instead. In some cases, those questionnaires either aren't detailed enough, or aren't suited for investors of all knowledge levels.

If you're asking someone, “Here's three hypothetical market scenarios; which one bests matches your risk tolerance?” most people have no idea how to answer that question. That's another big problem people seem to miss.

Finally, these firms don't do complex financial planning or services, like estate planning. There are some things they're not trying to do, and that only a human financial advisor can help you with.

ETF.com: Are these firms regulated differently than traditional advisory and wealth managers?

Easterbrook: It depends on what kind of group you're talking about, but for the most part, they're RIAs. Where you get into the tuition-financing firms or the real estate crowd funding, they've got a different set of regulations, but for the most part, the kind of B-to-C investment advice, investment or planning services, they're RIAs.

ETF.com: Your research shows that algo-based investing firms are leading the charge in terms of asset gathering and growth. They tell the investor what to buy, what to sell, all at a fund level, based on online surveys; which is to say, the way you answer your survey is hugely important. What’s the main benefit to going the algo-based route?

Easterbrook: The thing about algo-based advice is that people have complicated financial portfolios. In a lot of cases, you've got your 401(k) here; your IRA there; the taxable brokerage account at E*Trade; your spouse's 401(k) here; and you kind of lose sight of your total portfolio.

If you can afford a financial advisor that can act as your CFO, great. But if you can't, they’re very good at aggregating all your holdings and giving you specific buy/sell/hold advice, like, “Did you realize you actually don't have any exposure to real estate? Buy a REIT. You have too much exposure to international stock; buy this instead.” There's certainly value in algo-based advice.

 

ETF.com: Fees vary in these algo-based providers. Some are even free. Does the quality of advice vary as well? Do you get what you pay for?

Easterbrook: I think they proved that it's relatively easy to automate the process—aggregating your holdings, identifying where you have high-cost/poor-performing funds, where your asset allocation is off.

The algorithms can't factor in what age you are; they can't do complex financial planning yet. But it's not that hard to identify a fund you hold is performing poorly, or is very expensive and there’s a better passive option.

But you're right in the sense that you're getting what you paid for. You're only getting portfolio advice, and you're not getting the holistic advice a financial advisor can give you.

ETF.com: In what way are these firms going to impact the traditional financial advice industry? Do you expect them to eventually replace traditional advisors?

Easterbrook: No. I think, generally, traditional management firms that refuse to innovate over the long term will be in trouble regardless of what the startups are doing. Think of a typical full-service firm. They've got a big branch network; they emphasize quarterly face-to-face meetings.

That's very expensive. They have poor websites that don’t really fit the next generation of investors as you shift to Gen X and  Y. That's a challenge in and of itself, regardless of what the startup world is doing.

But I also think these firms are reinforcing a much lower price point for the cost of advice than what traditional wealth management firms offer. Even if they're not competing with those traditional firms today, they're competing over the long term by reinforcing a different set of expectations for the cost of advice.

ETF.com: If you're an investor, how do you go about deciding whether algo-based or online managed accounts from companies like Wealthfront, or a trade-mimicking platform, is right for you? Where do you start the process of figuring out which one of these outfits is best for you?

Easterbrook: That's a great question. Algorithm-based advice is really helpful if you have a complex portfolio with lots of holdings at different places. Say you have a 401(k), an IRA, taxable brokerage account, your spouse has a 401(k), and/or you want to review what your financial advisor's doing—you want a third-party review on the funds your advisor’s put you in.

For low-cost managed accounts, it’s great if you want to invest a lump sum. You’re going all in, and starting over.

Now, if you want to work with a human financial advisor, but don't really want to meet them every quarter face to face because you’re more concerned about costs, you use an online-only financial advisor. And if you want to try to beat the market and try to save some money doing it, you should try “trade mimicking.”

Finally, if a lot of your money is locked up in a 401(k), you're not trying to allocate it, there are firms focused just on that.

It’s a big space and there's something for everyone if they can only find it. It’s hard.

ETF.com: As a final thought, you’ve spent a couple of years researching this space. What really stands out to you in the evolution of this so-called next-generation financial advice?

Easterbrook: The reason we called it “next-generation investing” is because we think there's a big shift taking place as we go from boomers to Gen X, then Gen Y investors. People have been predicting that traditional advisors will have to get more transparent, have to lower costs, have to offer better digital services for years. And they still haven't in a lot of cases.

As this generational shift happens, you've got different preferences that will make it harder for traditional wealth management firms to connect with Gen-X and Gen-Y. At the same time, you've got this next generation of startups that, broadly speaking, have lower costs, lower minimums, better transparency, better websites, less conflict of interest.

These divergent forces are bad news for traditional wealth management firms.

It could be a very potent disruption in the industry. It will be interesting to see what happens to the industry. I'm not naive; inevitably some of these startups will fail, but many will succeed.

 

 

Find your next ETF

Reset All