The rise of Robo-Investment Advisors in North America.
Why this trend will not sustain in the long run?
By: Tariq Ali Asghar
Technology is growing at the speed of thought and is poised to disrupt the Financial Services Industry (and possibly dismantle the contemporary cost embedded banking structure) in the next decade. One recent manifestation of this mega trend has been the unprecedented rise of the robo-investment advisors. Venture capitalists in North America alone have invested over one billion dollar into these robo models and have created one of the biggest technology bubble in the recent history. Unfortunately this trend continues. Today there are scores of robo-investment advisors cropping up in North America. Needless to state this mega trend has jolted the traditional banking and investment industry, from Vanguard to Fidelity. It is no surprise that the seven big banks in Canada and the big insurance companies are feeling the pressure now and have embarked on the journey of becoming robo-investment advisors.
Who are robo-investment advisors and how are they different from the traditional investment structure? See diagram 1 below which explains how a robo-investment advisor functions. They are technology driven Portfolio Management algorithms that would minimize the need for any human intervention during the investment process. These robos run complex algorithms in the background while using the following seven key steps:
- In the first step, the software lets you login with your username and assigned password. This step is quite simple and straightforward.
- The second step entails KYC (Know Your Client) procedure. The software throws a series of questions with the end goal of getting an accurate information about the risk profile, time horizon and tax situation.
- The software then processes this information and connects with the virtual assistant sitting in the background to build the most optimal portfolio for you. For example, if you are a conservative investor, the portfolio might have 70% investment recommendation in the fixed income category. In contrast, if you are an aggressive investor, the portfolio would comprise of 70% equity. The life cycle investing path, typically followed by robos using low cost exchange traded funds as investment vehicles, educates us that the former will be for the older people and the latter for younger folks.
- In the fourth step, some robo-investment advisors perform “gap analysis” on your investments. They make projections on the difference between the current rate of your investments and the rate anticipated by the recommendations of robos. The caveat here is that these projections do not have any scientific foundations validated by the independent third party. Many Monte Carlo simulations are designed as marketing tools.
- Once the client accepts these recommendations, the system automatically generates an IPS (Investment Policy Statement), which is an implementation plan geared toward achieving your investment goals.
- The next logical step is the execution of the actual trade. The robo-investment adivsors are connected to back-office custodians and brokers who would execute the trade. All the documents of trade-execution and compliance are generated and maintain digitally.
- Finally the robo-investment advisors arrogate on the fact that they can do automated rebalancing (as well as tax harvesting) that would align the portfolio to the “Efficient Frontier”.
Despite the apparent success and relatively fast growth of robo-investment advisors like Wealthfront, Betterment, Future Advisors in USA and Wealthsimple in Canada, one should predict their future sustainability with a grain of salt. My view is that the current robo-investment advisor path is not sustainable insofar no single group of robos would be able to claim monopoly based on superior returns (performance) in future. In the investment world, all arbitrage opportunities are short lived (assuming that the leveraging of technology by robos is their main vantage point). More important, I am skeptical about the sustainability of this model in its current form and think that it will be ultimately replaced by a more comprehensive financial planning model which is run by humans and supported by machines (I am calling this model the “Cyborg Comprehensive Model (CCM)” and will be the topic of my next blog article). I have built my analysis, supporting my thesis regarding the unsustainability of robo-investment advisors, around five key dimensions:
Behavioural: This aspect is probably the most important dimension of achieving success or failure in investments. In my previous blog, I had underscored three key drivers of investments: Diversification, Discipline and Costs Minimization. All three factors are critical for success. However the weightage assigned by robo-investment adivsors to costs mitigation is highly exaggerated. Costs do matter in order to garner better returns but the more pronounced factor weighing heavily on the portfolio performance is “human behaviour”. Modern research has laid greater emphasis on human psychological factors like greed and fear in achieving the investment outcomes. It is no surprise that all algorithms run by robos are designed toward cost mitigation and not toward helping generate positive behaviour patterns, which would ultimately have a significant positive impact on the investment outcomes.
Strategic: The robos emerged with the agenda to leverage technology and grab bigger chunk of market share from the conventional players like banks and big investment houses like Vanguard and Fidelity. Ironically the traditional big players like Charles Schwaab, Fidelity and Vanguard reacted to this move by robos and also jumped on the bandwagon of robo technology. This unexpected move diluted the initial euphoria of first robo advisors quite a bit. It is because of the gigantic size of Vanguard and Charles Schwaab, robos like Betterment and Wealthfront lost their first mover advantage. If this strategic trend continues, then the robo space will be over-crowded and of course commoditized with no sizeable advantage going to any single player or a group of robo-advisors.
Investment: Just imagine the fact what would happen to passive investing (couch potato) strategies professed by robos in a market downturn? Low cost exchange traded funds just mimic the market index (of course not perfectly and with certain degree of tracking error). When the markets are plummeting, it is logical to believe that these indices will map the path of markets and will do no better than markets – even if the diversified optimal portfolio leverages technology and algorithms in the background. The recent success of many robo-investment advisors has been predicated on the phenomenal success of S&P 500 Index in the aftermath of 2008 crisis. It is a fallacious assumption that this performance would continue in a major market downturn. See diagram 2 which explains why the “couch potato” or passive investing strategy would not always succeed in a bearish market. The diagram explains that it is quite possible that the active investment actually does better than the passive strategy. For example is the fund manager is using inverse index funds or other reverse strategies.
Financial (Revenues): It is an open secret now that the margins are moving under extreme pressure in the new regulatory environment. Compliance costs are already putting pressure on the margins and this trend will be going north in the years to come. The robo-investment advisors who have based their success on the core strategy of cost-differentiation are reeling under the pressure of extremely low margins already. This tight situation has greatly hampered the revenue generation capacity of robo-investment advisors. Simple arithmetic tells us that these robos need trillions of dollars under their belt, in order to justify the valuations done by the venture capitalists supporting their investments into these technology hubs. The blocker for robo advisors, on the path of gaining bigger chunk of the market, is the unexpected turnaround of big traditional players who are now striving to become robo as well. Given the potential commoditization of the offering of the robo-investment advisors, the probability of emerging robos grabbing even $100 billion in the next five years is highly improbable, what to talk of $1 trillion ballpark.
Intuitive: As diagram 3 explains, the value proposition of robo-investment advisors is not predicated on viable assumptions. For example:
- (a)-The premise that low cost funds would always entail better returns is not always correct. The key driving force behind this assumption is the fact that the portfolio is rightly designed and can weather market oscillations in the long term. This may not always be the case.
- (b)-The robos claim that the “systematic automation” increases the efficiency of portfolio deployment by cutting the manual processes. While this claim is partially true, the main objection to this premise is that it is not just automation which generates leverage in investments. What about “human behaviour” which bears significant influence on the portfolio returns? Automation deployed around wrong underlying algorithms will do more harm than good.
- (c)-Finally robos claim automated rebalancing. This is based on the assumption that the transaction costs of such a rebalancing are low. Again this may not be the correct underlying assumption.
To summarize: in this article I have analyzed the mega trend of the rise of robo-investment advisor and argued that this is not sustainable in the sense of giving a viable competitive advantage to a single player or a group of first movers in the long run. Ultimately this market space will be highly commoditized given the emerging regulatory regime as well as countervailing act by the big conventional players. The key takeaways from this analysis are as follows:
- There is a strong likelihood that the robo-investment advisor model will get commoditized soon, if not done already. The driving force behind this commoditization is going to be the unexpected building of robo path by the conventional players and big financial institutions.
- The robo model predicated on low cost passive investing (couch potato strategy) has yet to withstand the tremors of a bearish stock market.
- Low cost investing, as claimed by robos, is not the holy-grail of investments. Modern research says that the holy-grail is ingratiated in the “human behaviour”. The robos cannot provide algorithms to discipline or reinvent the “human behaviour”. This opens up the question of having a Cyborg Model rather than just a robo model for consistent success.
- The crazy valuations and massive VC funding flowing into robos do not justify the limited bandwidth of robos in terms of assets under management. Giants like Vanguard, Fidelity and Charles Schwaab have already positioned themselves as robos, and are a major impediment to potential asset acquisition by the emergent robos.
Overall, my analysis emphasizes the fact that the true future Revolutionary Model is not going to be Robo but Cyborg. Stay tuned to learn about this Cyborg Model in my future blogs. This Cyborg Model is my core vision of the Emerging Star Platform.