As in most industries, technological innovation is disrupting the money management business. That’s most visible in the remarkable growth of exchange-traded funds (ETFs), which were enabled by the revolution in high-speed data processing and telecommunication.
Since the start of 2001, cumulative inflows into equity ETFs totaled $2.0 trillion through June of this year (Fig. 1). From 1990 through the end of 2000, equity mutual funds attracted $1.8 trillion net inflows (Fig. 2). Since the start of 2001, they’ve attracted only $885 billion. Since the start of the current bull market during March 2009, ETFs attracted $1.5 trillion, while equity mutual funds attracted only $149 billion. In other words, so-called “passive” asset managers have clearly benefitted from the tech revolution at the expense of “active” managers.
ETFs provided low-cost investment alternatives and pushed existing players to lower their fees on products new and old to remain competitive. Most recently, Fidelity introduced two fee-free index funds. The Fidelity Zero Total Market Index Fund and the Fidelity Zero International Index Fund won’t charge investors any fees regardless of the amount they invest. Zero. Zip. Zilch.
Nevertheless, thanks to the recent bull market, equity mutual funds racked up capital gains totaling $7.5 trillion through June. Now there is another challenge for traditional active managers. Around 2008 to 2010, a group of upstarts began offering active money management services that used computer programs to decide what and when to buy or sell. Computer programs allocate the funds, rebalance them, and sometimes take tax losses. Human assistance is often available via the phone.
Better known as robo-advisors, firms like Betterment, Wealthfront, and Personal Capital have clients fill out a questionnaire online about their financial status and goals; using that information, a computer places customers’ money in ETFs. Clients benefit from low minimum investments and low fees—often just a quarter or half of a percentage point.
In short order, the big, traditional players took notice and either bought robo-advisors or developed their own AI-empowered offerings. Vanguard, Schwab, Merrill, and other large established companies now offer their own AI-managed funds, often in conjunction with advice from their own financial advisors. I asked Jackie Doherty, our contributing editor, to have a look at recent developments in this growing corner of money management. Here’s her report:
(1) Numbers getting bigger. Robo-advisors may have started small, but their assets under management are growing fast. According to estimates in a Juniper Research study published earlier this year, revenue from robo-advisor technology was about $1.7 billion in 2017, but it will grow to $25 billion by 2022 as assets under management expands from about $330 billion last year to $4.1 trillion in 2022.
“Juniper found that robo-advisors are broadening the appeal of the wealth management market, with their delivery method via intuitive smartphone apps making the investment process far more convenient, offering a compelling reason for millennials to invest,” a company press release stated.
(2) Big fish buying minnows. Large money managers have two choices: build or buy. Among those in the buy camp is BlackRock, which purchased a large minority stake in the UK’s Scalable Capital; founded in 2014, the firm has clients in the UK, Germany, and Austria. That followed BlackRock’s 2015 acquisition of US robo-advisor FutureAdvisor.
Now small financial companies are partnering with FutureAdvisor to offer their own robo-products. US Bancorp has partnered with FutureAdvisor to offer a product called “Automated Investor” that rolled out in June. “The investment portfolios have been created by U.S. Bank wealth management professionals and will have access to ‘the same investment content from our investment team’ that all wealth management clients receive,” Mark Jordahl, president of US Bank Wealth Management, said in a 6/19 American Banker article. “The technology seeks to optimize returns and help minimize risk, and automatically rebalances investments as the markets change, he said. Users can receive a free analysis of their investments to see how they are performing and how they can potentially improve.” The fee: 50 basis points.
Along the same line, Fifth Third has partnered with Fidelity’s digital platform, Automated Managed Platform, to develop a Fifth Third digital wealth management offering. “Fidelity’s automated advice platform launched later than offerings from competing firms such as Schwab and BlackRock. However, the firm has more than a dozen clients already live and using Fidelity AMP, with more than 150 firms in the pipeline, including a mix of banks, RIAs and broker-dealers,” a 6/5 American Banker article reported.
Meanwhile, some of the minnows have started to offer banking products. In Q2, robo-advisors Acorns and Stash launched checking account and debit card options, according to the Q2 Robo Report by BackendBenchmarking. SoFi, a fintech lender with a robo-advice product, now offers checking accounts and credit cards. Wealthfront is exploring offering checking and savings accounts.
(3) Scale matters. Those robo-advisors who have failed to gain scale or attract a deep-pocketed buyer are closing up shop. Hedgeable, a robo-advisor launched in 2010, announced in July its plans to close. The firm had almost 1,700 clients and $79.9 million in assets. The news follows the December closing of WorthFM, a robo-advisor focused on female clients.
Hedgeable’s “demise indicates that the ‘market of independent automated investment services is saturated and the players need either hundreds of thousands of accounts or millions of dollars in order to succeed.’ Small digital advisory firms can’t afford to survive against the big legacy institutions or Betterment or Wealthfront,” said Bill Winterberg, founder of FPPad.com, a technology consulting firm, in a 7/13 Thinkadvisor.com article.
Betterment has $14.1 billion of assets under management, and Wealthfront has $10.2 billion. But even those levels are dwarfed by the robo assets that the large money management firms hold. Vanguard Personal Advisor Services has $101.0 billion of assets under management in its robo arm, and Schwab Intelligent Portfolio Products has $33.3 billion, according to the Robo Report.
(4) The report card. The Robo Report has a quarterly ranking of how various robo-advisors fare. The firm opens up and funds accounts at various robo-advisors. In taxable accounts, it seeks a moderate allocation of 60% stocks and 40% bonds for an investor in a high tax bracket.
No one robo-advisor providing equity advice attained a top-three performance position over more than one of the three time periods measured—ytd, one year trailing, and two years trailing—as of Q2’s end. Vanguard’s Total Portfolio, which can include stocks and bonds, was in third place for the one-year-trailing ranking and in first place for the two-year-trailing ranking. SoFi’s fixed-income portfolio was the top performer ytd and in third place for one-year-trailing performance.
None of their blended portfolios matched the returns of the S&P 500 because the portfolios typically include allocations to bonds, foreign equities, and value stocks. Even their equity portfolios, which may include international or value stocks, failed to match the 14.0% one-year-trailing S&P 500 return as of 7/31. Two of the highest one-year-trailing results came from Fidelity Go, 12.2%, and Wealthfront, 12.4%. Fidelity charges 0.35% annually and has no minimum investment, while Wealthfront charges 0.25% and has a $500 minimum. On the other end of the spectrum, FutureAdvisor and Betterment’s equity portfolios had among the lowest one-year returns, 7.8% and 8.0%, respectively.
(5) Note of caution. Robo-advisors are undoubtedly the flavor of the month on Wall Street; however, investors should be certain to understand exactly how the robos’ algorithms work. Dr. Ed’s book Predicting the Markets illustrates why it’s important to do so.
He writes: “Gary Smith, a professor of economics at Pomona College, wrote an August 31, 2017 opinion piece for MarketWatch titled ‘This Experiment Shows the Danger in Black-Box Investment Algorithms.’ Gary was an assistant professor at Yale when I attended the graduate program in economics, and I learned much from him. We remain good professional friends and like-minded about the cluelessness and irrelevance of most macroeconomic research.
“In the article, Gary reported running big-data, black-box investment algorithms to explain the S&P 500 daily for 2015. He let data-mining software loose on 100 variables that might be correlated with the S&P 500 stock price index. His experiment considered all possible combinations of one to five variables, including all 75,287,520 possible combinations of five variables. Several of them worked great but then failed miserably in 2016. He wisely concluded: ‘We should not be intimidated into thinking that computers are infallible, that data-mining is knowledge discovery, that black boxes should be trusted. Let’s trust ourselves to judge whether statistical patterns make sense and are therefore potentially useful, or are merely coincidental and therefore fleeting and useless.’”
Algorithm suspicion will be important to develop for years to come.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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