Home >Mint-lounge >Indulge >Robo wealth advisors: has the terminator arrived?

“Fintech" is the new buzzword in finance and unusually it is not about alchemical financial engineering. As the name suggests, Fintech is the application of technology to transform the way in which traditional financial functions are performed. Unlike traditional technology companies servicing the financial sector, Fintech firms are at the crest of a wave of Schumpeterian creative destruction about to wash over the financial services industry. Firms in the sector cover a broad space from retail to investment banking. Technology is not only being applied for process-oriented tasks like processing payments, but is also taking over relationship-based work where the human touch was considered key. For example, peer-to-peer lenders and loan marketplaces seek to displace the loan officer by disrupting the age-old banking function of matching savers to borrowers.

Similarly, the machines are upending the investment advisory sector by making your friendly wealth manager redundant. Start-ups offering automated portfolio construction and management have gained significant traction over the last five years and garnered nearly $20 billion in assets under management (AUM). Although this is a tiny fraction of the overall AUM (estimated variously between $60 trillion and $80 trillion), “robo advisors", as these firms have been dubbed, are challenging traditional incumbents by offering tailored services at a lower cost with greater transparency. While the US accounts for a majority of the market, other countries are also seeing start-ups in the robo advisory space. For example, Nutmeg in the UK and Scripbox and ArthaYantra in India are part of the robo advisory start-up trend. That established players consider these new firms a threat can be seen from the fact that Charles Schwab, with nearly $2.5 trillion in client assets, saw fit to offer its own robo advisory service earlier this year to head off the challenge posed by Fintech insurgents such as Wealthfront, Betterment and FutureAdvisor.

While these are interesting developments, the question you may ask is whether robo advisors contribute positively to your wealth. This means looking at what they add to portfolio returns and detract from costs.

Almost all robo advisor websites tout the superior investment performance of their portfolios. Although marketing may create a beguiling image of a computerized black-box earning market-beating returns, the truth is more prosaic. Returns can be marginally higher largely due to following a sensible investment approach of portfolio diversification and periodic rebalancing. This avoids behavioural biases of concentrated bets and overtrading that lay low most individual investors. Usually, good wealth managers provide the same advice. However, the area where machines have the edge over a human is in their ability to precisely optimize portfolios to an individual’s risk appetite by crunching risk-reward metrics over a much larger universe of investible assets. Unlike a human wealth manager, a machine determines asset allocation looking at the numbers rather than skewing portfolios based on favourites or getting caught up in the investing flavour of the month. The uber-rational approach may not transform your portfolio into a Renaissance Medallion (US-based fund which has apparently never had a down year since 1993) clone, but it is unlikely to do much worse than the market.

Although higher returns are debatable, the clinching argument for using robo advisors is cost. Utilizing scalability and cheap computing power, they are upending the lucrative business model of traditional wealth managers by offering services at a fraction of the cost. They not only undercut the relatively high advisory and management fees charged to clients, but are also more transparent on other charges being levied. High fees have traditionally been accepted, albeit grudgingly, by clients due to an aura of investment wisdom built around itself by the industry (ever notice the raft of acronyms suffixed to a typical wealth manager’s name?) and its position as a gatekeeper to asset markets and funds. However, technology has exposed the first and disrupted the second. The average wealth manager trained in finance cannot compete with a computer on applying modern portfolio theory and processing data. Moreover, technology and the Internet have made it possible to disintermediate the middle man (or at least replace him with something much cheaper). Access to markets and funds is available at the click of a button to most. This explains the growing acceptance of robo advisors and the growing unease of traditional firms at these upstarts.

Does this mean the machines are going to take over? As with all innovation, there is a euphoria that the new business model is going to replace the old. However, just as the ATM did not displace the bank teller, robo advisors are unlikely to replace all wealth managers. Moreover, the nature of the wealth management process requires coexistence. Work such as portfolio construction and rebalancing based on the tenets of finance theory can be left to the computer, but higher value-added tasks cannot. Identification of significant opportunities such as new business ideas or market reversal requires a human touch (would a computer have bought Amazon in 2002 or Apple in 1997?). Moreover, wealth management is not entirely about investing. Other financial activities are also important such as tax minimization strategies, estate planning, etc. The standard ones can be done by a computer, but it cannot figure out loopholes and advise on legal interpretation. Therefore, robo advisors are likely to become a complement to the traditional wealth management services rather than supplement them outright. The current take-up of robo advisors already shows the process in play. The machines are being embraced as an avenue for hassle-free, low-cost investing by people who do not have the time or the inclination to either invest themselves or pay a wealth manager to recommend a standard ETF (exchange-traded fund).

Shashank Khare is an investment professional and writer. After studying engineering at IIT-D and business administration at IIM-A, he entered the world of credit derivatives before CDS became a four-letter word. Having successfully batted through the crises, he now indulges his passion for economics, finance and policy.

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