In the last few years many industries have seen their traditional business models being disrupted by startup companies making use of new emerging technologies, such as blockchain or artificial intelligence, to better capture the consumers’ needs. One of these industries has been the financial industry. The intersection between financial services and technology is generally referred to as FinTech and touches upon all traditional services, from payment services to decentralized lending platforms. Among others the financial industry has seen a rise of so called robo-advisors. Growth in the robo-advisory industry has been significant in the last years, especially in the U.S., but Europe is also seeing more and more companies gain market share and expanding across state borders.
What are robo-advisors and what do they do?
The term “robo-advisor” is composed of two separate terms, “robo” and “advisor”. “Robo”, derived from the term robot, refers to an automated process, meaning without any human action, and “advisor” to the service provided by professional advisors. Basically, robo-advisors are digital platforms that provide automated, algorithm-driven financial planning services with little to no human supervision. The term “robo-advisor” is currently mostly used in the context of financial investment advisory, although other industries such as the insurance, health care or real estate industry are also increasingly affected.
The first step in the advisory process is getting to know the potential customer and identifying his risk profile. Since robo-advisors provide their services online, either via their websites or their mobile phone applications, with no human interaction between the advisor and the client, the assessment of the client’s risk profile happens online as well. The process is similar for all robo-advisors; when signing up with a robo-advisor, the client is asked to fill out an online questionnaire, in order for the robo-advisory company to be able to make a profile of its customer and build an understanding of what the client seeks with their investments. Based on this profile, the robo-advisor would then start to make specific investment recommendations.
Robo-advisors predominantly invest in products that require no or less active portfolio management such as exchange traded funds (ETFs). ETFs are funds that track indexes like the NASDAQ-100 Index, S&P 500, Dow Jones, etc. By simply matching and not trying to outperform the market, they do not need active management, which makes them inexpensive to run. Additionally, they are interesting as they allow investors to invest in a diversified portfolio, so they are less affected by single-security price changes.
Their target customer
Over the past years, financial innovation has presented investors with an increasing number of different financial options making financial decision making ever more complex. Investing is complex because, in addition to understanding the financial markets and the ever widening number of different available products, investors must be able to among others evaluate risk and understand tax implications. As a consequence, investors with low financial literacy are particularly likely to make poor financial decisions. That is why these financial non-literate are the main target customers of financial advisors.
Within this group of investors with low financial literacy, there are those that do not own enough money to go to a traditional financial advisor or those who are simply too cost sensitive to pay for their services. Indeed, robo-advisors often appeal to less-wealthy investors, given the availability of low-minimum and low-cost portfolios. The average size of a robo-advisor account is between $20,000 and $100,000, suggesting that the greatest traction has been achieved amongst the mass market and mass affluent demographics. With banks increasingly downsizing advisory services especially for less-wealthy investors, robo-advisory services are becoming the only way for these people to participate in financial investment.
Additionally, robo-advisors’ target customer would encompass all those people who have a certain distrust in the traditional financial institutions, especially since the financial crisis of 2008, but nevertheless want to save money and invest to see their wealth grow. By being fully transparent on their fees and by letting their clients to some extend individualize their portfolio, robo-advisors still let their customers feel like they are being empowered and in control.
How are they disrupting the industry?
As already mentioned, robo-advisors’ main selling point and advantage over traditional financial advisors, is their comparatively lower fees. Traditional wealth managers charge in general more than 3% of their clients’ portfolios every year, even when there are few changes to the portfolio outside of occasional rebalancing of assets. When robo-advisors provide similar services they will generally fix their price at less than 1% of the invested amount.
These lower fees have their roots in the online nature of robo-advisors’ services. Traditionally, financial advisors have to sign scanned papers and even meet the client in person. This takes up much time and sets a limit on how many customers could be served by one wealth manager and at the same time is also very expensive for the advisor. By providing most of the interaction online, robo-advisors can save time and costs. Indeed, the provisioning of the whole service via an online platform additionally reduces personnel and asset costs while a higher number of customers can be served. At the same time, the low complexity of these products makes them easier to explain to a wide range of customers.
The opportunities are non-negligible and more and more startups are entering the wealth management industry with this new business model, gaining market shares at an astonishing quick rate. In the US, assets under management of these startups have increased from $2.3 billion in 2013 to $20 billion in the first quarter of 2017. In Europe, the number of assets currently managed by robo-advisors is not publicly available, but it is said that the total number should be close to 5–6% of that in the US and growing at an equally quick rate. As a result, banks and traditional asset managers are increasingly trying to grasp for footholds through acquisitions and cooperations. For instance, BlackRock acquired in 2015 FutureAdvisor and recently expanded its reach overseas by partnering with a German robo-advisor to distribute its iShares ETFs.
Anika Ley, Media Master Mind
