If the Terminator Passed his CFA

Rise of the Robo-Advisors

Co-Written by Mick Emmett

“Don’t look back. Something might be gaining on you.” — Satchel Paige

You might find this hard to believe while waiting a few days for a check to “clear” in 2017, but banks and other financial institutions are investing heavily in technology to run their businesses now — and in the future. They actually have to if they want to stay in business, because there is a whole industry of mostly small companies and startups called “FinTech” that is booming. And what scrappy, young, t-shirt and jeans-wearing company wouldn’t want to eat [insert name of any big bank]’s lunch? Such is innovation…

It All Starts With Power, Bandwidth and Storage

The consumer-facing technology that financial institutions have been offering makes our lives easier, with online banking and investing being the most obvious examples (well, except for when the hackers take over). It also makes life easier for the financial institutions — and less expensive. Remember getting those weighty envelopes with monthly statements in the mail along with pages of transactions and fine print, maybe some cancelled checks, and whatever marketing pieces they jammed in? The United States Postal Service sure does.

Beyond the basic stuff we can all do on our phones, tablets and computers, there’s a lot going on behind the scenes. Thanks primarily to the exponential growth in computational power, bandwidth and cheap storage, FinTech companies, and the applications and services they build, have become big business. According to just-departed Comptroller of the Currency, Thomas Curry, investment in FinTech worldwide has grown from $1.8B to $24B in just the last five years. We’ll let others go into FinTech 101 because our goal here is to dive right into the innovation stream. And man oh man is it flowing fast…

“Robo” without the actual robot, because that would be weird

One area of financial service innovation that is scaling rapidly is robo-advising. Built on top of machine learning algorithms that draw on powerful computing resources to find patterns and make predictions, robo-advisors are online platforms that automate asset allocation via algorithms for a fee that is typically much smaller than that of human advisors. Machine learning is a subset of artificial intelligence (AI), which is remaking a number of industries before moving on to replacing humanity. OK, the latter isn’t guaranteed to happen…yet, but the former is happening now in a big way.

Case in point: a recent study by Accenture found that banks — according to three quarters of the bankers surveyed — will use AI as the primary method of customer interaction within the next three years. And 80% of the surveyed bankers believe that AI will revolutionize information collection as well as client interaction.

It makes total sense for banks and other financial institutions to push their chips into the middle of the robo-advising table. Using less resources AND operating exponentially more efficiently means more revenue with less effort — what bank (or other company, or person for that matter) wouldn’t love that? If artificially intelligent robots can make 400 hamburgers — made to order, no less! — in an hour, is there really anything they won’t be able to do? That’s a question many highly paid, non-steel and cable-wearing investment advisors are wondering these days.

Rise of the (Investment Advisor) Machines?

One of the areas the Accenture report cited as “ripest” for tech innovation is the advisory business, shocking just about…no one. Also not surprising is the number of companies that have sprung up to take advantage of this market inefficiency. And why wouldn’t they — it’s a massive opportunity. According to a recent report from Deloitte, estimates predict between $2.2 and $3.7 trillion in assets will be managed by 2020 with the help of robo-advisory platforms. And by 2025 it’s expected to be in the $16 trillion neighborhood.

Some well-known platforms, like Wealthfront and Betterment, are fully automated, while others have some human interaction as a complement to the AI technology for specific situations. For the majority of investors, who have relatively small amounts to invest and don’t really need to pay human advisors just to put them in an index stock fund or a similar basic investment portfolio, an AI-powered robo-advising platform is worth a close look. It offers a low entry point to the consumer while at the same time acting as a financial market provider in the same way that banks and investment firms have traditionally done. Yeah — the line is getting murkier. And many are making the switch or just starting with a robo-advisor and skipping the well-dressed, well-educated human being in the well-appointed downtown office altogether.

We’d be remiss if we wrote an article that talked about technology, financial institutions and murkiness without mentioning regulation. And no one wants to be remiss. So stay tuned for an upcoming article about regulation and where it could go.

Spoiler Alert: Faster, Cheaper, Better Wins in the End

In his book “The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail,” author Clayton Christensen tackles the very subject we are discussing now with the advent of robo-advising disruption. It’s unfortunate for steel industry executives back in the 1960s that they didn’t have such a book, otherwise they could have avoided the rise of steel minimills. It’s been too long to activate a spoiler alert on this, so we’ll just go ahead and say that over the course of 30 or so years the minimills innovated relentlessly while the big steel companies kept doing what they had always done, and the steel business has never been the same.

The same story and plot also apply to the mechanical excavator industry, as Christensen details in the book. In this case there is a conflict between the “old” (cable-actuated mechanical shovels powered by steam initially and then gasoline) and the “new” (hydraulics), and you’ll never guess which technology wins.

There are other industries mentioned in the book, but Christensen’s main point is the question: Why is success so difficult to sustain? The short answer: market leading companies don’t respond effectively to disruptive technologies and innovations until it’s too late. There are many reasons — some of them even sound — for not changing in any meaningful way in the face of disruption. And it’s not easy to tell which innovations are disruptive, which are “sustaining” (like when cable-actuated shovels switched from steam to gasoline engines as opposed to hydraulics in the mechanical excavator example), and which are a bust. Even having good management (which Christensen also writes about) is no guarantee of making the right choices.

Get Rich or Die Tryin’

Unlike their distant steel and mechanical excavator industry predecessors, financial industry executives have had The Innovator’s Dilemma (and a ton of books like it) to learn from. Those with money to burn also have legions of expensive consulting companies to walk them through the potential minefields and prepare for the future. None of these options is foolproof, but suffice to say there are a lot more resources and data to draw on. And a lot of past mistakes to learn from.

The thinking here at Realm Labs is that the big financial players will eventually “win” the robo-advisory race. They won’t do it efficiently, or fast, or smoothly. And they certainly won’t do it inexpensively. The endgame will involve blunt force via acquisitions, building applications for millions that some other company built for thousands, and promoting their new robo-services to their millions of existing customers — something no FinTech company can match. With the word “trillion” involved, they will get their act together because that pie is too rich to not have their hands in it.

It will also be interesting to see how rough the transition process goes because, in a sense, going big into robo-advising has a direct impact on a lot of employees who are already providing these services. You know, sort of like every manufacturing business is very familiar with. There will always be a place for the high net worth investors with human financial advisors, but most of the advising will eventually be automated.

To paraphrase a man named after money: some of the existing and yet-to-be-created FinTech companies will get rich (mostly by being acquired or selling their IP), and a lot more will die tryin’. Along the way they will innovate. Some, like SoFi, might even take a huge lead in their FinTech niche and hold on for a long time. But the vast majority are not built for the long game.

We’re Not in Kansas Anymore

Where this all leads is a place where what we think of as a bank or an investment firm or even insurance company does not look familiar. Tech companies that build financial platforms will look like financial institutions, and financial institutions will offer tools that look like tech companies (think Amazon). The examples of this crossover effect are multiplying. A particularly interesting one was announced just yesterday when Swedish payments startup Klarna (now valued at $2.25 billion) announced that it is getting a full bank license and legally changing its name to Klarna Bank (thought it will continue to operate as just “Klarna”).

Regulations will also have to keep pace (hello RegTech!) and consumers will need to embrace more innovation despite the security concerns. The AI-fueled robo-advising horse is already out of the barn, down the road, and picking up speed as she goes. And she sure as hell isn’t looking back.