Traditional active investment managers, such as Fidelity Investments, are under attack. The growing shift from active to passive investment management over the past decade has resulted in record outflows from active funds each year. On another front, the rules-based approach to passive investing combined with society’s increased reliance on and trust in technology has led to the rise of robo-advisors. Active investment managers are struggling to keep up with these industry shifts and technological innovations, but must adapt or risk further erosion of their market positions.
Active vs. Passive 101
The goal of active investing is to beat the returns of the overall market. Active investment management companies devote resources and human capital into studying and analyzing companies, sectors, industries, and the overall market in order to recommend particular stocks and bonds that (potentially) present good investment opportunities. Investors put money into an actively-managed fund, which is overseen by a professional portfolio manager that makes these investment decisions on the investor’s behalf in attempt to beat the market and provide the highest returns. For their efforts, active investment managers typically charge fees of about 1.0 – 1.5% of assets under management.
Passive investing has been around since the 1970s when the first index fund was created, but has grown exponentially since the 2008 financial crisis that put the whole industry under the microscope. Passive investing is based on the theory that markets are efficient and investors are better off putting their money into funds that track an index, such as the S&P 500, instead of trying to pick stocks and time the market. Studies show that it is highly unlikely for an active investment manager to consistently beat the market over time. Passive investment managers have much lower operational costs thanks to having no need for Research, so they are able to charge much lower fees. The average expense ratio on a S&P 500 index fund is about 0.15%.
The predictability of passive investing’s rules-based approach has made it a natural target for automation via algorithms of tech companies. Enter robo-advisors.
Rise of Robo-Advisors
Robo-advisors are automated financial advisor and investment services that use minimal-to-no human intervention. Web and mobile platforms are utilized to provide an investor questionnaire to gather information on the investor’s goals, risk tolerance, and timeline. Algorithms automatically generate a portfolio of index funds and ETFs. And the investor’s portfolio are constantly monitored and automatically rebalanced as needed.
Robo-advisors made their entrance in 2008, with two of the original and still prominent robo-advisor firms being Betterment and Wealthfront. According to Statista’s 2017 Personal Finance FinTech Report, the 2017 global robo-advisor segment size was about $226 billion in assets under management, with about $183 billion of that coming from the US. This global figure is currently less than 1% of the total worldwide assets under management, but is expected to experience a 43% CAGR and grow to over $1.3 trillion by 2022.
Benefits of Robo-Advisors
The main advantage of a robo-advisor is the low fees. Robo-advisors are essentially software companies built around algorithms, which means they have significantly lower overhead costs when compared to traditional investment management companies. They are able to pass these cost savings on to investors in the form of low fees. Robo-advisor fees are typically 0% – 0.25% depending on the amount invested.
Additionally, for any one who is even remotely tech-savvy, robo-advisors are very easy to use. In just a few short minutes you can download an app, answer a few questions, deposit your money, and voila…you’re investing! Gone are the days of trekking down to the local branch of a big financial services firm to speak with a financial adviser who may or may not have your best interests in mind. Or gathering the knowledge and confidence to manage a portfolio yourself online. We live in a time when we trust tech companies to arrange rides in strangers’ cars and overnight stays in strangers’ homes, and now we are trusting tech companies to manage our money.
Limitation of Robo-Advisors
Robo-advisors are designed to be simple and easy to use so that investors can use them without the need for much, if any, customer service. Because of this, robo-advisors are great for young, tech-savvy personal investors who are looking to get a start on investing. For those starting out a simple portfolio management tool is good enough. However, at this time robo-advisors are not able to handle the complex financial situations, such as retirement, taxes, and estate planning, that arise as we age, have families, and see our income grow.
What Traditional Asset Managers Can Do
Traditional asset management firms cannot sit back and ignore the growth of robo-advisors. While the segment size is relatively small right now, one has to remember robo-advisors have only been around for less than a decade and its been even less time since the proliferation of smartphones. Society’s growing reliance on and trust in technology will allow for the continued growth of robo-advisors. Traditional asset managers must partner with fintech firms or invest in their own technology to adapt to this changing industry dynamic.
An example is Fidelity Investments and their 2016 release of Fidelity Go. Fidelity Go is a cross between active management and a robo-advisor. The product is geared towards young, tech-savvy investors who are looking for a digital personal investing experience. Similar to robo-advisors, the system is based on a web or mobile platform which issues a questionnaire to gather basic information on the investor’s goals and then offers portfolio suggestions. The difference with Fidelity Go is there is some human intervention, with a portfolio manager ultimately responsible for managing the chosen funds and asset reallocation over time. Also, Fidelity Go offers live chat, phone, and email support, which is absent in most robo-advisors. With this product, Fidelity is able to rely on its core competencies of active management and customer service while still catering to the digital crowd.
Similarly, we learned from guest speaker, Lindsay Sutton, about John Hancock’s Twine, a simple app designed for couples to start saving and investing together. Again, questionnaires and algorithms are used to provide suggested portfolios, but there is some human intervention in the actual management of those portfolios.
Both of these examples show how traditional active investment management companies can adapt to this technological innovation. Offering robo-advisor-like products can act as a “bait-and-catch”, and as these customers age and their financial situations become too complex for robo-advisors, companies can funnel these customers into more traditional actively-managed products.