Digital advisors: not dead yet

Recently Morningstar issued a report on digital advisors questioning their business models and competitiveness compared to incumbents like Charles Schwab. It’s a thoughtful report and worth reading if you’re into this topic. Morningstar made two main points that seemed daunting to the company: (1) Digital advisors must grow 10–15x to become major, profitable businesses — from $1–2B in assets under management (AUM) per startup today to $20B+ AUM and (2) to get there, they will need to spend $150M+ each to acquire customers.

This argument captures a growing doubt about digital advisors — especially since Schwab launched its “free” service — but it feels tautological — to succeed digital advisors will have to get a lot bigger and raise a lot more money, therefore they are unlikely to succeed.

Both facts may be true, but that doesn’t mean they won’t happen. It’s worth a closer look at the actual economics of the digital advisor to understand why there is indeed a very good chance that some will breakout.

At the same time, I think the more interesting and fundamental argument has been missing from the debate — digital advisors are commoditizing a major portion of the financial advisory business. How does anyone win in a commodity business?

FIRST, WHY WILL DIGITAL ADVISORS REACH ESCAPE VELOCITY?

#1 The market is way bigger than Millennials. From the outside it may not be obvious that digital advisors go way beyond serving millennials. Their low-cost, online, user-friendly, 24 x 7 experience is well suited for millennials, but not only for millennials. Digital advisors like FutureAdvisor (where I am an investor) attract a demographic that is literally representative of the United States, by age, geography and gender. That means the market opportunity for digital advisors is already bigger than some believe and does not rest solely on “millennials growing assets.” This is already a mass affluent offering ($100,000 — $1M in investable assets).

#2 Unit economics are better than you think. Related to the first point, average household balances will be higher than most believe, materially improving unit economics. Digital advisors are a classic disruptive technology, starting with the “less attractive” low balance customers that professional advisors do not serve well, and rising to serve higher and higher value households. FutureAdvisor’s average household balance is already $140,000. At $30,000 — $80,000, Betterment and WealthFront are lower and frame the doubt of the doubters, but even they will see balances rise faster than millennial wealth growth as they attract mainstream investors who accept digital advisors as the new normal.

Strong unit economics + large market + outside funding equals great business in the making. Asset management is inherently a great business. It’s a sticky, recurring business model in which the manager does better when the client does better (i.e., if assets appreciate, advisor fees increase). We’re already seeing household balances >$100,000, fees between 25–50bp and customer acquisition costs (CAC) < $500. Churn is the unknown, but even with an industry average customer life of 8–10 years, we see Lifetime Values (LTV) / CAC of > 3x a ratio that supports scaling. Gross Margins approach 80%. These are excellent metrics for businesses that are just a few years old and only beginning to test the best customer acquisition channels.

#3 Funding follows economics. Finally, Morningstar’s observation that a digital advisor may have to spend more than $150M acquiring customers to get to $20B AUM is probably right — though the flywheel of free organic growth and referral could kick-in to reduce that — but I see that funding as rational and likely. Yes, it depends on the broader economy and a healthy venture investment environment, but with attractive unit economics and continued penetration of a $34 trillion market, the money will probably be there. To put $150M over five years in perspective, Charles Schwab spends $250M per year on marketing.

BUT THE REAL ISSUE IS COMMODITIZATION

The most subtle contribution of digital advisors will be the most transformational. In just three years, digital advisors have shown that some financial advice can be provided for a fraction of the historical fees. As if to say it got the message, Charles Schwab actually launched a free service. This end of the market looks like a commodity business in the making. I can choose among multiple digital advisors offering similar investment models, with similar investment returns and similar user experiences.

Commodity businesses are rough, but when it comes to managing people’s money there will be winning strategies in the race to zero costs.

1. Brand will matter. People are giving digital advisors their money and if people will pay more for toothpaste because Colgate makes it, they will pay more for a digital advisor they trust. In the marketplace lending sector, the student loan startup SoFi seems headed in this direction with solid brand extensions into mortgages, personal loans and super soft and comfy t-shirts.

2. People pay for performance. Absolute performance is great, but so is personalized, goal-based performance (e.g., help me fund the care of my elderly parents or help me compensate for having most of my wealth tied to my employer’s success). One of the most exciting advances from digital advisors will be building low cost, scalable investment models that can still be personalized.

3. Premium services. The world is full of commodity players who failed to move up the stack to premium services, but I believe wealth management is more like Microsoft’s Windows operating system (which positioned it to win at the Office application layer) than it is Verizon’s internet service (which positioned it to win next to zero of the over-the-top revenue earned by Google, Facebook, Twitter, et. al.). Managing the bulk of someone’s wealth makes you very important to them and tells you a lot about them. Own the customer relationship and you get the right to sell additional services — alpha seeking investment products, insurance, retail brokerage, etc.

4. Actually be the lowest cost. If you’re a commodity, act like a commodity. I think this play belongs to the incumbents for the foreseeable future who, like Schwab, can give the portfolio rebalancing away for free knowing they make money from the cash balances and the use of their own investment products in the portfolio allocation. If that’s right, startup digital advisors can and should maintain their fees and focus on building value via #1 — #3.