Are robots taking over wealth management?

One of the challenges of innovation is attempting to superimpose the rules governing traditional products or services onto the new, disruptive ones. Driverless cars, for example, need legal authorisation to travel, and the artificial intelligence in Google’s self-driving machine now qualifies as a legal driver, according to US vehicle safety regulators.

Providers of automated investment advice, or robo-advisers, find themselves in a similar situation. Like the programming behind the revolutionary vehicles, the algorithms governing risk-profiling data and automated advice must be recognised as equal to any investment adviser but also held to the same standards.

For example, the UK’s Financial Conduct Authority (FCA) recently said robo-advisers will be subject to the rules on the suitability of personal recommendations or decisions to trade imposed by the Markets in Financial Instruments Directive II (MiFID II), as human advisers are. Despite recent regulatory efforts to normalise the new financial technology (fintech) companies, results have been mixed.

Cheaper and clearer?

First appearing in the US less than a decade ago, with companies such as Betterment and Wealthfront among the best-known pioneers, robo-advisers have begun to spring up in Europe and Asia-Pacific. They aim to serve clients’ investments whatever their size, at a fraction of the price charged by traditional wealth managers and with a clear fee structure.

For example, no minimum deposit is required to invest through Betterment, while Wealthfront does not charge for investments of under $10,000 and only 0.25% annually above that. This compares to a typical 1% charged by the rest of the industry, which is often accused of passing on hidden costs to the client.

Robo-advisers typically determine clients’ risk profiles based on online questionnaires, notes Chris Williams, automated advice director at UK building society Nationwide and founder and former CEO of robo-adviser Wealth Horizon. This skips the traditional introductory face-to-face meeting between client and financial adviser that is not dissimilar from a “hostage situation” and is a process clients find excruciatingly long and generally gruesome, he says. This improves the overall client experience.

Globally robo-advisers now manage $30bn of assets, according to 2015 data from consultancy Oliver Wyman. The company expects this figure to grow to $500bn by 2020, with 50% of the asset pool managed in North America. Large wealth managers such as UBS, Goldman Sachs, BlackRock and Charles Schwab have also invested in the innovative platforms.

Regulatory favour

Policy-makers have begun to warm to the robo proposition too. The FCA considers artificial intelligence the solution to the UK’s ‘advice gap’ – the lack of affordable, professional investment advice for the less affluent. The regulator has created a unit specifically to deal with, and support innovation in, this field.

Similarly, the Monetary Authority of Singapore is closely studying these new solutions, and Australia’s regulator is opening up communications channels with financial entrepreneurs, “turning up to all fintech events and providing e-mail addresses and mobile phone numbers [of staff], which for a regulator is almost unheard of”, says Sydney-based Astrid Raetze, a partner at law firm Baker & McKenzie.

But while artificial intelligence and the smart use of data are reinvigorating efforts to democratise financial services, the first alarm bells have been sounded regarding the limits and risks of the first wave of robo-advice. In June this year, Betterment briefly halted trading in the chaos that followed the UK’s vote to exit the EU, something Massachusetts secretary of state William Galvin described as a “great disadvantage” for customers.

This prompted the Massachusetts Securities Division to issue specific regulatory guidance for the 700 or so financial advisers in the state to ensure those using a robo-adviser “meet the fiduciary duties owed to their clients” – in other words, put clients’ interests above any other considerations, including the firm’s profitability. In an earlier note, in April the division had raised concerns over the ability of robo-advisers’ algorithms alone (as they are structured now) to carry out such duties.

Short-lived robots?

In the UK, a report by wealth manager SCM Private has brought to light other challenges facing robo-advisers. Alan Miller, co-founder and chief investment officer of the company, which has also launched a campaign to improve fee transparency in wealth management, believes the robo-adviser promise is hard to deliver on, and that in its quest for financial inclusion, the FCA has created an imbalance between traditional advisers and automated ones.

“Rightly or wrongly, there’s been lots of pressure, particularly in the UK, about the advice gap. The regulator wants to be seen to encourage companies that in their minds can deal with this gap. But this should not be done simply by breaking the rules,” he says. Mr Miller was alluding to the FCA’s ‘sandbox’, in which he fears a number of nascent robo-advisers may be placed and allowed to operate without fully meeting the regulations imposed on others, until they reach a certain size. The FCA did not respond to The Banker’s requests for comment.

More worryingly, SCM’s research into 10 UK-based robo-advisers carried out in July found that the level of estimated costs to acquire customers means these firms would not turn a profit until their 11th year of operation. And that, says Mr Miller, might be an optimistic view.

“A senior fintech executive says that acquisition costs are even higher than our report estimated, £180 ($220.50) per account [over estimated returns of £147.50]. So the assumption of breaking even in 11 years is too generous; it might take 15 years or more,” he says.

Building a market

MiFID II could further raise wealth managers’ costs as they will need to ensure information about clients is up to date and provide periodic suitability reports for discretionary managers, something smaller firms may be less well equipped to absorb.

However, at UK robo-adviser Nutmeg, chief investment officer Shaun Port has no doubts over the sustainability of the model. “We’re investing for growth, that’s what our backers want us to do. They want to us to democratise wealth management [and] have large amount of people using our service,” he says. “We could cut our marketing budget and become profitable but this is about building a market and building a long sustainable business that really has an impact.”

Assets under management doubled at Nutmeg in 2015, says Mr Port, who expects this rate to be replicated in the next few years. “We’re in what I’d consider wealth management 1.0, where we make the business more efficient, more stable, and then, on that platform, we can build more products,” he says. Currently, robo-advisers’ most common investment product tends to be exchange-traded funds.

Mr Port adds that claiming less wealthy individuals are less profitable customers is “an excuse”, and sees great value for society in servicing them. “These people are completely underserved,” he says. “They don’t have access to wealth management solutions, they are sitting on cash, and having a pension sitting on cash when you’re in your 20s is a really bad idea.”

Modernisation needed

Nationwide’s Mr Williams says that the sector is in dire need of modernisation, beginning with the lengthy process undertaken by traditional advisers to assess clients’ risk profiles. Looking at online search engines, he notes, it is evident that “people are looking less for a financial adviser and more for financial advice”.

Although most people would prefer to go through filling in long forms in their own time without a formal meeting, this also raises concerns over the accuracy of responses that cannot be tested through human interaction with a professional. No one would notice a tired customer providing less thought-through answers in order to get through the questionnaire quickly.

Paolo Galvini, co-founder and chairman of digital wealth management company MoneyFarm, offers a different point of view. He believes the quantity of data collected as well as the way certain answers are elicited by carefully phrased questions can reduce inconsequential answers, as well as bias.

“The good thing about data is that it’s objective and trackable. There has been an explosion of [robo-advisers] in the past couple of years and not every one is building these things in the soundest way,” he says. “But if you’re doing your job properly, you can capture relatively precisely the risk attitude of your client.

“For us, it’s irrelevant if a client is prudent or not. The [investment] industry doesn’t really work based on this concept. If I profile you with an aggressive profile, I’m in a position to sell you more and more aggressive products.”

MoneyFarm serves customers in the UK and Italy and its assets under management have grown by more than 200% since its creation in 2015.

Transparency move

The regulatory focus on objectivity and transparency will support the robo-adviser case. Among MiFID II’s requirements are rules for greater fee transparency, something the traditional industry is generally accused of lacking.

Mr Miller is as strong a critic of robo-advisers as he is of traditional wealth managers. He sees MiFID as an ally of the fintechs and dismisses talk that Brexit would keep this particular rule out of the UK.

“This is a distant hope among the dinosaurs of the UK investment industry because they don’t want to show customers how much [their services] really cost,” he says. “MiFID II [would force] them to be transparent and honest with their customers for the first time in 25 years by forcing all MiFID-regulated companies to share the [charges] through the investment chain.”

Mr Miller adds that most wealth managers do not include the charges paid to other players involved – such as brokers, for example – that are ultimately covered by eating into the customer’s investment returns. Smaller or new players find it hard to compete in an industry driven by big brands and the trust they evoke in customers, because creating such a brand is an expensive exercise that is out of the reach of small providers. “When you suddenly see that the total [charge] is 3% per annum rather than 1% and that there are alternatives such as robo-advisers and more efficient managers, that will create a more level playing field,” he says.

Keeping up with the speed of innovation will continue to be challenging for regulators around the world as pressures to create a fertile environment for innovation continue, alongside the need to protect consumers and their savings.

The world of investment is evolving with society. Younger generations’ ease in interacting and sharing personal and financial data online will continue to shape the provision of investment services in the future. Much of the robo-advisers’ growth expectations in the Oliver Wyman report are based on demographic developments and the assumption that the key market of tech-savvy young customers of today will have access to larger investable sums in the future.

Future wealth warning

But there is a caveat, says Mr Miller, as the "unmet millennials" that the automated advisers are aimed at may turn out to be just not wealthy enough to justify the robo-advisers’ existence. “[The theory goes that] in 15, 20 years’ time, these people will have amounts to invest and robots will benefit,” he says. “The catch with that is that most of these companies won’t exist in 20 years’ time. The other catch, unfortunately, in the UK and elsewhere, with high housing costs and relatively low salaries, is that they won’t have much to invest.”

As with driverless cars, robo-advisers have the potential to disrupt their sector and bring great benefits to society if consumer protection rules are met. But like the innovative vehicles, they will need to be commercially sustainable to bring about real change. In addition, regulators will need to ensure consumers are protected from any future failures in innovation.