The Envestnet Edge, March 2015
Keep Your Friends Close and Your Robo-Advisors Closer
It may have taken years for automation to disrupt the financial services industry, but a recent rapid growth in robo-advisors likely means that significant changes lie ahead in the asset and wealth management landscape. Are human advisors facing a threat, or is it an opportunity?
On July 1, the film Terminator: Genysis will debut in theaters across the United States and throughout the world. It will be the fourth installment of a series that began more than 30 years ago, which in many ways defined contemporary fears of the rise of the machines: a world where the brilliant programs designed by humans themselves become the masters and turn against their human creators.
This cultural meme permeates modern life. Think of The Matrix movies and their dystopian vision of a world in which machines enslave humans; and before that, the widely popular Isaac Asimov stories that began with I, Robot. The innovations of technology that went into hyper-drive in the 1990s often have been seen as both empowering and liberating. They also are twined with what is a not-so-subtle anxiety that technology may cause more harm than good.
As many are aware, the financial services world now is experiencing its own form of this fear with the rise of “robo-advisors”: wealth management software that potentially can replace many of the traditional functions of an advisor. Most of the companies offering these services are tech start-ups that have attracted substantial venture capital funding – close to $500 million as of the end of 20141. In addition, established companies such as Schwab and Vanguard have unveiled their own software that can design an investment menu based on the answers to a set of questions that a human advisor would traditionally ask. Examples are: “How old are you?” “What is your income?” “When do you plan to retire?” Once the answers are obtained, the program can progress even deeper.
To date, the volume of assets in absolute terms that these new firms manage is small compared to the overall level of assets under management. It is at $19 billion, compared to the $33 trillion in potential investable assets. True, the growth curve has been steep and impressive for robo-advisors, having nearly doubled in 2014, but that is from a tiny base, and the absolute amount remains equally tiny.
Still, the financial services world legitimately is attuned to the changes afoot. It’s not a question merely of the degree of change now, but, rather, how much there potentially will be in the future. Here, too, there are ample precedents set by other industries. The financial services world in general and its asset management and wealth management subsets in particular have been laggards when it comes to the disruptive effects of technology. The only other industry that has been so slow to integrate the information technologies of the past two decades is health care, where only now, for instance, medical records are being digitized.
The rise of the machines
A look at what has happened over the past decades to other industries suggests that concerns about the potentially disruptive effects of robo-advisors may be justified. Traditional manufacturing has been more disrupted by automation and robotics than by free trade and outsourcing labor to China and elsewhere. Automated and flexible factories now can churn out more stuff with a smaller portion of the labor market than it once required. Manufacturing in the United States now employs a fraction of the workforce it did fifty years ago. For example, in 1970, nearly 25% of the American labor force was engaged in manufacturing; today, that figure is less than 9%2. Yet that 9% of workers (about 12 million today) produces much more than the 25% did in 1970.
That is the dual-edge of technology: it minimizes input by creating efficiencies and reducing the cost of doing whatever it is we do, and at the same time results in maximizing output by producing a greater number of goods and services. The problem for societies is that labor is not merely an input; it also is a vital aspect of a stable social order. So reducing the input cost of labor simultaneously allows us to do more with less and can reduce income, at least in the short-term. Long-term, our collective prosperity has been increasing, but not without massive disruptions along the way.
This is the context for today’s concern in the wealth management space about robo-advisors. The broader financial services industry already has had a taste of similar disruption: the upsurge of ATM machines at retail bank branches in the 1990s that largely decimated the bank branch labor force. For investors, the rise of quantitative investing enhanced by complicated software running on algorithms changed the nature of investing. It led directly to ETFs and a host of other passive investing strategies that offer investors much lower-cost exposure to stocks and bonds. Hence the concern about active-versus-passive investing. Although the level of overall assets in passive investments is still minimal compared to those under active management, the growth of passive strategies has been far more robust, as has been the increase in robo-assets.
Don’t fear the machines—embrace the change
The fear of the machines is both understandable and overstated. Tech apostles are prone to grandiose statements about the future effects of what they offer, but they can be tone deaf about the human element. Machines and software have been most effective at either replacing human beings or enhancing their ability to perform tasks that are simple and binary. Assembling a car or accepting deposits or investing in a basket of stocks – these are straightforward processes amenable to automation. But more sophisticated tasks also may be vulnerable, including those that require complex calculations such as the performance of a portfolio and identifying its risk characteristics.
What may be less susceptible to automation are activities that involve multiple variables that change constantly. Planning for a financial future fits into that category. A person can answer a suite of questions to establish an investment menu. Those answers can frame a portfolio and a plan, but will be valid only so long as the answers don’t change over time, and if the underlying investments perform as forecast. That is seldom the case. Hence the profound need for people who are constantly focused on these issues to respond to changing needs and shifting answers.
A perceived threat is really an enhancement
The concern that robo-advisors, or quantitative strategies, or passive investing eventually will obviate the need for human advisors and investors is overblown. We do not perceive a rise of the machines as a threat; rather, we see them as an enhancement. Yes, these new companies and programs may make it increasingly harder for professionals to offer cookie-cutter services. These companies and programs will challenge advisors and investors who adopt a paint-by-numbers approach, and that will be all for the best. Few aspects of our lives are paint-by-numbers, nor should be our plans for investing, for retiring, and for creating a stable financial future.
The likely result is a world in which both robo- and flesh-and-blood advisors thrive and build upon one another. Software programs are only as good as the people who program them, even if smart-machines that can learn and adapt lie in our future.
The wealth management and financial services world is facing technological disruption. That is a fact that needs to be accepted, not feared nor fought. It will change how money is managed and channeled. But it will not replace the need for skilled people, and may, instead, increase it. The threat is not that the tools of information technology will become ever more robust; rather, it is that the people who can best use them will resist doing so. The wealth management world has been sheltered from many of the sea changes caused by information technology. That is coming to an end, and at the same time, is opening up a world of possibilities.
Barring a quantum leap to sentient machines, robo-advisors will not replace their human counterparts – whether in the near or distant future. The ability to provide holistic solutions tailored to different clients can’t be achieved easily by automation. When taken together, financial planning, asset selection and allocation, portfolio construction and rebalancing, and tax management constitute a highly involved endeavor that only human advisors can address appropriately. Seldom will a “set it and forget it” strategy ever meet a client’s requirements throughout their investing lifetime. Rather than fear the robo-advisor, human advisors should welcome them with open arms and recognize the opportunity to enhance their own service model. Advisors might, as one example, cede certain basic allocations and investments to a robo-advisor or platform in order to shift their focus toward establishing more effective partnerships with their clients and developing more insightful solutions along several dimensions. The larger point is that wealth managers, like every segment of society, will be best served by embracing the rise of new technologies rather than fearing them.
1 Source: "Investors Snap Up Online Financial Advisers", Wall Street Journal, 12 February 2015.
2 Source: EPI Briefing Paper #388, Economic Policy Institute, January 2015
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